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Credit Rationing Grinblatt and Titman, pp. 557-560.

Credit Rationing Grinblatt and Titman, pp. 557-560. Exhibit 16.5 Multi-Universal’s Project Payoffs. Result 16.9   Firms with the potential to select high-risk projects may be unable to obtain debt financing at any borrowing rate when risk-free interest rates are high.

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Credit Rationing Grinblatt and Titman, pp. 557-560.

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  1. Credit RationingGrinblatt and Titman, pp. 557-560. Exhibit 16.5 Multi-Universal’s Project Payoffs Result 16.9   Firms with the potential to select high-risk projects may be unable to obtain debt financing at any borrowing rate when risk-free interest rates are high. Financial Markets and Corporate Strategy, David Hillier

  2. Lenders’ Credit Analysis I • Suppose the riskless rate of return is 0% and that Project A is chosen • In order to break even, investors will ask for €112.5 since • 100=0.8*112.5+0.2*50 • Which project will be chosen by firm? • Project A gives equity holders • 0.8*(130-112.5)=14 • Project B gives equity holders • 0.2*(150-112.5)=7.5 • So Project A is chosen and investors are happy to invest

  3. Lenders’ Credit Analysis II • Suppose the riskless rate of return is 12% and that Project A is chosen • In order to break even, investors will ask for €127.5 since firm now needs 112 invested to ensure expected rate of return of 12%, i.e. • 112=0.8*127.5+0.2*50 • Which project will be chosen by firm? • Project A gives equity holders • 0.8*(130-127.5)=2 • Project B gives equity holders • 0.2*(150-127.5)=4.5 • So Project B is chosen and investors are not happy to invest • There is credit rationing. Because of moral hazard, no interest rate will make lenders willing to invest in the firm, even if it has positive NPV!

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