Capital Gains Taxes, Irreversible Investment, and Capital Structure
AbstractPersonal taxation can be an important determinant of corporate investment and financing decisions if the marginal investor is taxed. I develop a dynamic capital budgeting model under realization-based capital gains taxation that highlights distinct cross-sectional and time-series implications. Capital gains taxation creates an embedded tax timing option that reduces investorsâ€™ uncertainty about after-tax payoffs in downstates. The inherent asymmetry in personal taxation diminishes the value of the firmâ€™s option to delay, and ceteris paribus lowers the initial threshold for making an irreversible investment compared to the zero tax rate case. However, the asymmetry disappears gradually and the investment threshold shifts up, if investors reset their tax basis before the firm exercises its investment option. Hence, firms that are ex-ante identical can have different investment policies ex-post depending on their stock price evolution. The lock-in effect of embedded capital gains also alters the debt-equity tradeoff. Firms employ more equity financing, the lower the basis to price ratio of their owners. As a result, capital structure is path-dependent on past firm performance. The combined effect is consistent with cross-sectional evidence on the relation between leverage and Tobinâ€™s Q. Lagged external-financing weighted market-to-book has explanatory power for leverage in the cross-section
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Bibliographic InfoPaper provided by Society for Economic Dynamics in its series 2004 Meeting Papers with number 688.
Date of creation: 2004
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Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
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Capital Gains Taxation; Capital Structure; Investment; Real Options; External Financing;
Other versions of this item:
- Norman Schurhoff, 2004. "Capital gains taxes, irreversible investment, and capital structure," 2004 Meeting Papers 592b, Society for Economic Dynamics.
- Norman Schürhoff, 2005. "Capital Gains Taxes, Irreversible Investment, and Capital Structure," FAME Research Paper Series rp131, International Center for Financial Asset Management and Engineering.
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-08-02 (All new papers)
- NEP-CFN-2004-08-02 (Corporate Finance)
- NEP-PUB-2004-08-09 (Public Finance)
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