Effects of personal taxes and equity issuing costs on the firm's investment decision

The existence of preferential taxes on capital gains relative to ordinary income is widely understood to create a systematic preference for internal rather than external equity financing. This preference is magnified by the existence of issuing costs on new equity. This paper develops a procedure to account for these market imperfections in terms of an adjusted net present value that directly adjusts a project's net present value calculated without regard to the imperfections. Once the correct adjustment procedure is developed, the practical implications of personal taxes and issuing costs on the firm's investment behavior clearly emerges. These market imperfections have created a discontinuous function for the firm in obtaining equity capital. Many rational wealth-maximizing firms are forced to make investment decisions in a situation similar to capital rationing as the separation theorem between investing and financing does not generally hold. This explanation of a potentially long-run need for capital rationing is consistent with otherwise perfect capital markets.