The use of derivative financial instruments in the past decade has made it flexible and efficient for firms to manage taxation. Derivative financial instruments can affect taxes by altering the timing and character of reported income subject to tax. In this thesis, we set up a theoretical framework to show how firms exploit tax-timing and tax-character options to enhance firm market value. Firms exploit tax-timing options when they realize losses immediately but defer gains indefinitely. They exploit tax-character options when they realize losses as ordinary losses rather than capital losses. Firms can exploit both tax-timing and tax-character options by using derivative financial instruments. Data collected from the EDGAR database of the U.S. industrial firms tends to support the hypothesis that firms use derivatives to exploit tax-timing options. We also examine how taxation affects firm market valuation under clean surplus accounting. Under corporate taxation, based on the Feltham-Ohlson (1995) market value measurement model, we show that firm market value can be expressed as the bottom line accounting data, i.e., the book value and the abnormal earnings, as well as the tax data-tax-based market valuation model. The tax-based market valuation model provides a theoretical framework for the analysis of the effects of corporate taxation on firm market value. Firms may use derivatives to save tax by exploiting tax-timing and tax-character option value, and thus enhance market value. Agency costs such as financial reporting costs may reduce, but may not eliminate the benefits from exploiting tax-timing and tax-character option value.
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