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Valuation of Irreversible Entry Options under Uncertainty and Taxation

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Author Info
Luis H. R. Alvarez ()
Vesa Kanniainen ()

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Abstract

We analyze the tax effects on a potential firm with an irreversible entry option and subject to risky post-entry earnings. We formulate the problem in terms of optimal stopping and derive both the necessary conditions for optimal entry and the value of the optimal premium by relying on the classical theory of diffusions and the Greenian representation of the stochastic value functional. We show that to make the entry option invariant with respect to the tax policy when the government owns a call option on a fraction of firm's earnings, the tax allowance has to satisfy a first-order non-linear differential equation. We derive qualitive results for the neutrality of the tax policy. Using standard geometric Brownian motion to model price uncertainty, we provide examples of the requirements for tax invariance. The Johansson-Samuelson theorem is re-examined.

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Publisher Info
Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number CESifo Working Paper No. 144.

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Date of creation: 1997
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Handle: RePEc:ces:ceswps:_144

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Related research
Keywords: Optimal entry premium; tax policy; Johansson-Samuelson theorem; regular diffusion process; Green-kernel; optimal stopping;

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Find related papers by JEL classification:
C61 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming - - - Optimization Techniques; Programming Models; Dynamic Analysis
D21 - Microeconomics - - Production and Organizations - - - Firm Behavior
D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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  1. Alvarez JR, Luis & Kanniainen, Vesa & Södersten, Jan, 2000. "Why is the Corporation Tax Not Neutral? Anticipated Tax Reform, Investment Spurts and Corporate Borrowing," Working Paper Series 2000:4, Uppsala University, Department of Economics. [Downloadable!]
    Other versions:
  2. Niemann, Rainer & Sureth, Caren, 2002. "Taxation under Uncertainty -- Problems of Dynamic Programming and Contingent Claims Analysis in Real Option Theory," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
  3. Paolo Panteghini, 2002. "Asymmetric Taxation under Incremental and Sequential Investment," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
    Other versions:
  4. Panteghini, Paolo, 2000. "On Corporate Tax Asymmetries and Neutrality," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
    Other versions:
  5. Boehm, Hjalmar & Funke, Michael, 2000. "Optimal Investment Strategies under Demand and Tax Policy Uncertainty," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
  6. Vesa Kanniainen & Paolo M. Panteghini, 2008. "Tax Neutrality: Illusion or Reality? The Case of Entrepreneurship," Working Papers 0803, University of Brescia, Department of Economics. [Downloadable!]
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  7. Sinn, Hans-Werner, 1999. "Inflation and Welfare: Comment on Robert Lucas," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
    Other versions:
  8. Paolo Panteghini & Guttorm Schjelderup, 2006. "To Invest or not to Invest: A real options approach to FDIs and tax competition," International Tax and Public Finance, Springer, vol. 13(6), pages 643-660, November. [Downloadable!] (restricted)
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