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In theory

In practice

Source of Rationing

1. Project Discovery

A business uncovers a good investment opportunity.

A business believes, given the underlying uncertainty, that it has a good project.

Uncertainty about true value of projects may cause capital rationing.

2. Information Revelation

The business conveys information about the project to financial markets.

The business attempts to convey information to financial markets.

Difficulty in conveying information to markets may cause rationing.

3. Market Response

Financial markets believe the firm; i.e.,the information is conveyed credibly.

Financial markets may not believe the announcement.

The greater the "credibility gap", the greater the rationing problem.

4. Market Efficiency

The securities issued by the business (stocks and bonds) are fairly priced.

The securities issued by the business may not be correctly priced.

With underpriced securities, firms will be unwilling to raise funds for projects.

5. Flotation Costs

There are no costs associated with raising funds for projects.

There are significant costs associated with raising funds for projects.

The greater the flotation costs, the larger will be the capital rationing problem.

The three primary sources of capital rationing constraints, therefore, are lack of credibility, under pricing of securities and flotation costs.

Researchers have collected data on firms to determine whether the firms face capital rationing constraints, and if so, to identify the sources of such constraints. One such survey was conducted by Scott and Martin and is summarized in Table 6.3.

Table 6.3: The Causes of Capital Rationing

Cause

# firms

%

Debt limit imposed by outside agreement

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