Tax Convexity , Investment , and Capital Structure ∗

This paper examines the interaction between investment and financing decisions of a firm using a real options approach. The firm is endowed with a perpetual option to invest in a project at any time by incurring an irreversible investment cost at that instant. The amount of the irreversible investment cost is directly related to the intensity of investment that is endogenously chosen by the firm. The firm is subject to a convex corporate income tax schedule in which profits are taxed at a higher rate while losses are taxed at a lower rate. At the investment instant, the firm can finance the project by issuing debt and equity such that the optimal capital structure is determined by the trade-off between interest tax-shield benefits and bankruptcy costs of debt. We show that the optimal investment intensity of the levered firm is identical to that of the unlevered firm. While the prevalence of tax convexity does not seem to affect the firm’s investment decisions, it lowers the firm’s optimal default trigger and leverage ratio in a quantitatively significant manner. Our findings thus suggest that any distortionary effect arising from tax convexity on the firm’s investment decisions is almost completely neutralized by the adjustment in the firm’s optimal capital structure. JEL classification: G31; G32; G33