Capital Budgeting with Taxes under Uncertainty and Irrevesibility

This article investigates the derivation of post-tax investment rules and neutral tax systems under risk neutrality and risk aversion for irreversible investment projects. Integrating taxes into real option theory, it can be shown that the possible approaches dynamic programming and contingent claims analysis yield identical investment rules under risk neutrality. Under risk aversion, contingent claims analysis requires a sophisticated capital market model which is still missing. In contrast, dynamic programming as an individual approach permits explicit investment rules at least in the pre-tax case. After taxes, both approaches fail to reach general solutions. Nevertheless, we succeed in proving neutral tax systems for the first time under risk aversion in the real option context using dynamic programming.