Investment under Uncertainty, Debt, and Taxes

We present an approach for valuing real investment projects taking into ac-count both personal and corporate taxation, and assuming that the project may also be financed by issuing incremental debt. The setting is a general-ized Miller equilibrium economy with differential taxation for bond-holders and equity-holders and with cross-sectional variation in corporate tax rates. We use valuation neutrality (the martingale operator is not affected by taxes) and holding-period neutrality (there are no tax-based incentives to adjust the investment holding period) of the tax scheme. Accordingly, we provide a certainty equivalent (risk-neutral) valuation framework taking into account taxation and valuation of tax shields, for capital budgeting projects both in case the firm can and can prevent default on debt payment. The certainty-equivalent operator is not affected by tax shields and is the same before and after personal taxes. Interest tax shields can be incorpo-rated by either adjusting the discount rate for interest tax shields (depending on the financincg system) or with an APV-like approach with interest tax shields being additive. We also analyze also the effect of debt financing on the value of the option to invest and on the exercise policy, including the effect of default risk. One of the findings of this work is that for low uncertainty a higher leverage can reduce the time-value of the real options and increases the probability of exercising these options. This effect is completely offset in case either the uncertainty or the leverage is high; i.e., when the firm is close to default