Working Paper: NBER ID: w18148
Authors: Stewart C. Myers; James A. Read Jr.
Abstract: We show how the value of a real option depends on corporate income taxes and the option's "debt capacity," defined as the amount of debt supported or displaced by the option. The value of the underlying asset must be an adjusted present value (APV). The risk-free rate of interest must be after-tax. Debt capacity depends on the APV and target debt ratio for the underlying asset, on the option delta and on the amount of risk-free borrowing or lending that would be needed for replication. The target debt ratio for a real call option is almost always negative. Observed debt ratios for growth firms that follow the tradeoff theory of capital structure will be lower than target ratios for assets in place. Our results can rationalize some empirical financing patterns that seem inconsistent with the tradeoff theory, but rigorous tests of the theory for growth firms seem nearly impossible.
Keywords: No keywords provided
JEL Codes: G31; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Corporate income taxes (H24) | Value of real options (G19) |
| Debt capacity associated with the option (D25) | Value of real options (G19) |
| Adjusted present value (APV) of underlying asset (G19) | Debt capacity (G32) |
| Target debt ratio (G32) | Debt capacity (G32) |
| Value of growth options (D25) | Observed debt ratios (G32) |
| Valuable growth options (D25) | Lower borrowing relative to assets in place (G32) |
| Implicit leverage associated with real call options (G13) | Explicit borrowing (Y60) |
| Real call options (G13) | Negative net debt capacity (G32) |
| Firms adjusting capital structure (G32) | Dynamics of target debt ratios (G32) |
| Growth options (D25) | Equity beta or standard deviation (C46) |