Firm Dynamics with Endogenous Collateral Constraints

Abstract

This paper studies the effect of limited collateral on firm growth. Asymmetric information about the quality of the projects the firm can undertake makes external debt costly. Collateral can mitigate this problem, but its availability is limited by the size of the firm. As a firm grows, more collateral becomes available, broadening the firm's access to external debt financing channels and lowering its cost of capital. The firm's growth decision is influenced by how effective additional collateral can be in lowering its cost of capital and the amount of assets it needs to accumulate to broaden its access to potential lending channels. A small firm may optimally choose to stay small when it is financially constrained and far from the size necessary to have access to formal lending. When the firm approaches the size necessary to access formal lending, the strong incentive to expand makes it locally risk loving.