This paper investigates the effect of inflation and taxes on the optimal duration of investments. The main conclusion is that inflation does not always increase the duration of investments. For example, in the case of equipment with a short replacement cycle, increased inflation tends to decrease the duration of the cycle. Contrary to the common theoretical analysis, these results imply that inflation may increase some forms of capital investments.

This paper demonstrates that preferred stock may arise as an optimal security in a tax-induced equilibrium. This result is driven by graduated tax schedules and by uncertainty. In a more general sense, our results can be interpreted as a template for including any security with a different tax treatment in a firm's capital structure. The first part of the paper demonstrates that the Miller equilibrium framework can accommodate more than two securities if different investor classes are taxed differently on each security and the tax schedule for each investor group is upward sloping. We then simplify the tax schedule, but introduce uncertainty, which implies the possibility of bankruptcy and the possible loss of tax shelters. The interaction of tax rates and seniority now affects the contribution of each security to after-tax firm value, as in some states the firm may not be able to pay either interest (or dividends) or even principal to its various claimholders. It is shown why and how these features, i.e. the various tax rates and seniority, determine the financing equilibrium, which is obtained by equating the expected marginal tax benefit of all securities. We demonstrate that non-profitable firms will tend to issue preferred shares whereas profitable firms will not find preferred stock advantageous in our framework. Comparative statics with respect to various tax rates are derived as well. These predictions are tested using a large sample of firms for the last 25 years. The empirical testing broadly confirms the theoretical predictions.

This paper evaluates the common practice of setting the strike prices of executive option plans at-the-money. Hall and Murphy [Hall, Brian, Murphy, Kevin J., 2000. Optimal exercise prices for executive stock options. American Economic Review 90 (2), 209–214] claim this practice to be optimal since it maximizes the sensitivity of compensation to firm performance. However, they do not incorporate effort and the possibility that managers are effort-averse into their model. We revisit this question while explicitly introducing these factors and allowing the reward package to include fixed wages, options, and stock grants. We simulate the manager’s effort choice and compensation as well as the value of shareholders’ equity under alternative compensation schemes, and identify schemes that are optimal. Our simulations indicate that, when abstracting from tax considerations, it is optimal to award managers with options that will most likely be highly valuable (i.e., substantially in-the-money) on their expiration date. Prior to 2006, the tax code and financial reporting standards provided incentives to award options that are closer to the money when issued than the options that were optimal in the absence of these considerations. Recent tax and reporting changes voided these incentives and thus we predict that these changes will induce firms to issue options with lower strike prices than those that were issued prior to 2006.