Personal Taxes, Leverage, and Real Investment

40 Pages Posted: 2 Jul 2004

See all articles by Erwan Morellec

Erwan Morellec

Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute

Norman Schürhoff

University of Lausanne; Swiss Finance Institute; Centre for Economic Policy Research (CEPR)

Date Written: June 2007

Abstract

This paper examines the impact of capital gains taxation on firms' investment and financing decisions. We develop a real options model in which the timing of investment, the decision to default, and the firm's capital structure are endogenously and jointly determined. Our analysis shows that capital gains taxes cause large distortions in firms' policy choices. First, by providing a hedge for poor corporate performance, capital loss offsets drastically erode the option value of waiting and induce firms to speed up investment. Second, firms optimally employ more equity financing, the higher the firm's stock price and the worse the firm's performance history. As a result, target leverage is path-dependent, non-stationary, and related to past performance and Tobin's Q in a way that is consistent with the empirical evidence.

Keywords: real options, capital gains taxation, capital structure

JEL Classification: G31, G32, H24, H32

Suggested Citation

Morellec, Erwan and Schürhoff, Norman, Personal Taxes, Leverage, and Real Investment (June 2007). Available at SSRN: https://ssrn.com/abstract=559003 or http://dx.doi.org/10.2139/ssrn.559003

Erwan Morellec

Ecole Polytechnique Fédérale de Lausanne ( email )

College of Management
Extranef Quartier UNIL-Dorigny
1015 Lausanne, CH-1015
Switzerland

HOME PAGE: http://sfi.epfl.ch/

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Norman Schürhoff (Contact Author)

University of Lausanne ( email )

Extranef 228
CH-1015 Lausanne
Switzerland
+41 (0)21 692 3447 (Phone)
+41 (0)21 692 3435 (Fax)

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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