00Thaler_FM i-xxvi.qxd

accumulate cash. So there is no reason that the issuance of “cheap stock”
should lower the hurdle rate for investment.

2.binding capital structure constraint,

no price-pressure effects

The next case to examine is one in which the capital structure constraint is
binding, but where price-pressure effects are absent—that is, one in which
dZ/dL≠0 and di/dE=0. In this case, Eq. (14) simplifies to

df/dK=D(1+k*)+(1−D)(1+CER). (15)

Based on Eq. (15), we have:

Proposition 4.When the capital structure constraint is binding and

there are no price-pressure considerations, the optimal hurdle rate

has the following properties: the hurdle rate is between the NEER

and FAR values of CER and k*, respectively; as Dapproaches 0, the

hurdle rate converges to CER, as in Proposition 1; as Dapproaches

1, the hurdle rate converges to k*, as in Proposition 2.

The intuition behind Proposition 4 is very simple. When capital structure
imposes a binding constraint, one cannot, in general, separate investment
and financing decisions. This is perhaps easiest to see in the case where
δ<0, so that the stock is undervalued and the firm would like to repur-
chase shares. For each dollar that is devoted to investment, there is less cash
available to engage in such repurchases, holding the capital structure fixed.

RATIONAL CAPITAL BUDGETING 617


 












 









  



 









  



Figure 17.1. Investment and financing policies when capital structure is not a con-
straint.