Real Options, Taxes and Financial Leverage
AbstractWe show how the value of a real option depends on corporate income taxes and the option’s “debt capacity,” defined as the amount of debt supported or displaced by the option. The value of the underlying asset must be an adjusted present value (APV). The risk-free rate of interest must be after-tax. Debt capacity depends on the APV and target debt ratio for the underlying asset, on the option delta and on the amount of risk-free borrowing or lending that would be needed for replication. The target debt ratio for a real call option is almost always negative. Observed debt ratios for growth firms that follow the tradeoff theory of capital structure will be lower than target ratios for assets in place. Our results can rationalize some empirical financing patterns that seem inconsistent with the tradeoff theory, but rigorous tests of the theory for growth firms seem nearly impossible.
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Bibliographic InfoPaper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18148.
Date of creation: Jun 2012
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Find related papers by JEL classification:
- G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
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