Real Options, Taxes and Financial Leverage

The Critical Finance Review has published “Real Options, Taxes and Financial Leverage” by Brattle Principals Stewart Myers and James Read. This paper develops a procedure for calculating after-tax values of real options, including the value of interest tax shields on debt supported or displaced by the options. The valuation procedure also reveals option debt capacity and predicts the impact of real options on corporate borrowing.

The paper fills two major gaps in the theory and practice of corporate finance. One is a gap in capital budgeting. Although research in real options has been underway for well over 30 years, the literature has been silent on whether and how to incorporate taxes and debt capacity in real-option valuation. As a result, textbook treatments of two closely related topics—the valuation of real options and the valuation of assets in place—have been disconnected.

The second gap is in research on capital structure. Some empirical results that seem inconsistent with the tradeoff theory may be explained by debt targets for firms that hold real options. For example, the low debt ratios of profitable growth firms—an empirical observation often cited as evidence against the tradeoff theory—is actually a direct prediction of the theory if growth opportunities are real call options and option leverage displaces explicit borrowing. But the dynamics are complex. If real options are important, the tradeoff theory does not predict constant observed debt ratios nor does it predict debt ratios that follow any simple target-adjustment model.