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Capital Gains Taxes, Irreversible Investment, and Capital Structure

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  • Norman Schürhoff

    (HEC, University of Lausanne, FAME.)

Abstract

This paper studies the corporate policy distortions caused by realization-based capital gains taxation at the personal level in a dynamic trade-off theory model. The Lock-in effect of embedded capital gains creates severe conflicts of interest between incumbent and new investors. The firm's optimal policy exhibits path-dependency and non-stationarity, since the taxe basis of the firm's owners is a valuable conditioning variable for corporate decisions. Ex-ante identical firms follow very different investment and financial policies depending on their stock price evolution. Firms delay irreversible investment further the lower tax basis of their owners falls. The reason is the investment hedge provided by personal tax loss offsets weakens as investors reset their basis. Capital gains taxation also creates incentives to time equitzy issues. Firms employ more equity in their capital structure the higher the stock price-to-basis ratio, since locked-in investors with out-of-the-money tax timing options value the firm less than the market. The value gain from conditioning on the owner's tax basis is substantial. Using simulated data I show the combined effects are consistent with recent empirical evidence on the relation between leverage, Tobin's Q, and past performance.

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Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp131.

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Date of creation: Feb 2005
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Handle: RePEc:fam:rpseri:rp131

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Keywords: Capital Gains Taxation; Real Options; Capital Structure; Trade-off Theory; Market Timing.;

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