Investment Under Uncertainty, Debt and Taxes

29 Pages Posted: 6 Mar 2005 Last revised: 23 Dec 2019

See all articles by Andrea Gamba

Andrea Gamba

University of Warwick - Finance Group

Gordon Sick

University of Calgary - Haskayne School of Business

Mamen Aranda

University of Navarra - Business

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It is common practice in financial derivative valuation to use a discount factor based on the riskless debt rate. But, to what extent is this discount factor appropriate for cash flows emerging in capital budgeting? To answer this question, we introduce a framework for real asset valuation that considers both personal and corporate taxation. We first discuss broad circumstances under which personal taxes do not affect valuation. We show that the appropriate discount rate for equity-financed flows in a risk-neutral setting is an equity rate that differs from the riskless debt rate by a tax wedge due to the presence of personal taxation. We extend this result to the valuation of the interest tax shield for exogenous debt policy with default risk. Interest tax shields, which accrues at a net rate corresponding to the difference between the corporate tax rate and a tax rate related to the personal tax rates, can have either positive or negative values. We also provide an illustrative real options application of our valuation approach to the case of an option to delay investment in a project, showing that the application of Black and Scholes formula may be incorrect in presence of personal taxes.

Keywords: Investment under uncertainty, real options, capital structure, corporate and personal taxation, cost of capital, tax-adjusted discount rates

JEL Classification: G31, G32, C61

Suggested Citation

Gamba, Andrea and Sick, Gordon and Aranda León, Carmen Maria, Investment Under Uncertainty, Debt and Taxes. Economic Notes, Forthcoming, WBS Finance Group Research Paper No. 41, Available at SSRN:

Andrea Gamba (Contact Author)

University of Warwick - Finance Group ( email )

Scarman Road
Coventry, CV4 7AL
Great Britain
+44 (0)24 765 24 542 (Phone)
+44 (0)24 765 23 779 (Fax)

Gordon Sick

University of Calgary - Haskayne School of Business ( email )

2500 University Drive, NW
Calgary, Alberta T2N 1N4
403-220-7165 (Phone)
403-282-0095 (Fax)

Carmen Maria Aranda León

University of Navarra - Business ( email )

Edificio Bibliotecas-Este
Pamplona, 31080

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