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The effects of tax convexity on default and investment decisions

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Abstract:

The objective of this article is to examine how default and investment triggers change under different levels of tax asymmetry when firms face nonlinear tax schedules. Under a convex tax schedule, profits are taxed at a higher rate, while losses are taxed (or rebated) at a lower rate, thus reducing the risk shared by the government. This article presents a dynamic model based on the contingent-claims framework to explore the impacts of tax convexity on the triggers, and we find that the impacts vary significantly depending on several countervailing forces. Tax convexity has a nonmonotonic relationship with both the default and investment triggers, because of the government’s risk-sharing role. The default trigger is higher when tax convexity increases, while the growth option exerts a counteracting effect that lowers this trigger, creating an ambiguity in the investment trigger when changing the level of tax asymmetry.

Keywords: G30; contingent-claims model; default option; growth option; investment option; tax convexity

Document Type: Research Article

DOI: http://dx.doi.org/10.1080/00036846.2013.870653

Affiliations: 1: Department of Finance and Business Economics, Faculty of Business Administration, University of Macau, Taipa, Macau, China 2: Department of Finance and Insurance, Faculty of Business, Lingnan University, Hong Kong, China

Publication date: April 13, 2014

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