Reasons for Capital Rationing Constraints

In theory, there will be no capital rationing constraint as long as a firm can follow this series of steps in locating and financing investments:

1. The firm identifies an attractive investment opportunity.

2. The firm goes to financial markets with a description of the project to seek financing.

3. Financial markets believe the firm's description of the project.

4. The firm issues securities — i.e., stocks and bonds — to raise the capital needed to finance the project at fair market prices. Implicit here is the assumption that markets are efficient and that expectations of future earnings and growth are built into these prices.

5. The cost associated with issuing these securities is minimal.

If this were the case for every firm, then every worthwhile project would be financed and no good project would ever be rejected for lack of funds; in other words, there would be no capital rationing constraint.

2 For discussions of the effect of capital rationing on the investment decision, see Lorie and Savage (1955) and Weingartner (1977).

The sequence described above depends on a several assumptions, some of which are clearly unrealistic, at least for some firms. Let's consider each step even more closely.

1. Project Discovery: The implicit assumption that firms know when they have good projects on hand underestimates the uncertainty and the errors associated with project analysis. In very few cases can firms say with complete certainty that a prospective project will be a good one.

2. Firm Announcements and Credibility: Financial markets tend to be skeptical about announcements made by firms, especially when such announcements contain good news about future projects. Since is easy for any firm to announce that its future projects are good, regardless of whether this is true or not, financial markets often require more substantial proof of the viability of projects.

3. Market Efficiency: If the securities issued by a firm are under priced by markets, firms may be reluctant to issue stocks and bonds at these low prices to finance even good projects. In particular, the gains from investing in a project for existing stockholders may be overwhelmed by the loss from having to sell securities at or below their estimated true value. To illustrate, assume that a firm is considering a project that requires an initial investment of $ 100 million and has a net present value of $ 10 million. Also assume that the stock of this company, which management believes should be trading for $100 per share, is actually trading at $ 80 per share. If the company issues $100 million of new stock to take on the new project, its existing stockholders will gain their share of the net present value of $10 million but they will lose $20 million ($100 million - $ 80 million) to new investors in the company. There is an interesting converse to this problem. When securities are overpriced, there may be a temptation to over invest, since existing stockholders gain from the very process of issuing equities to new investors.

5. Flotation Costs: The costs associated with raising funds in financial markets, and can be substantial. If these costs are larger than the net present value of the projects being considered, it would not make sense to raise these funds and finance the projects.

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