Personal Taxes, Leverage, and Real Investment

Abstract

This paper examines the impact of capital gains taxation on firms' investment and financing decisions. We develop a real options model in which the timing of investment, the decision to default, and the firm's capital structure are endogenously and jointly determined. Our analysis shows that capital gains taxes cause large distortions in firms' policy choices. First, by providing a hedge for poor corporate performance, capital loss offsets drastically erode the option value of waiting and induce firms to speed up investment. Second, firms optimally employ more equity financing, the higher the firm's stock price and the worse the firm's performance history. As a result, target leverage is path-dependent, non-stationary, and related to past performance and Tobin's Q in a way that is consistent with the empirical evidence.

Keywords: real options, capital gains taxation, capital structure

JEL Classification: G31, G32, H24, H32