Small and informal firms account for a large share of employment in developing countries. The rapid expansion of microfinance services is based on the belief that these firms have productive investment opportunities and can enjoy high returns to capital if given the opportunity. However, measuring the return to capital is complicated by unobserved factors such as entrepreneurial ability and demand shocks, which are likely to be correlated with capital stock. We use a randomized experiment to overcome this problem, and to measure the return to capital for a sample of microenterprises. We accomplish this by providing cash and equipment grants to small firms in Sri Lanka, and measuring the increase in profits arising from this exogenous (positive) shock to capital stock. We find the average real return to capital to be 4.6 to 5.3 percent per month, substantially higher than the market interest rate. We then examine the heterogeneity of treatment effects to explore whether missing credit markets or missing insurance markets are the most likely cause of the high returns. Returns are found to vary with entrepreneurial ability and with household wealth, but not to vary with measures of risk aversion or uncertainty. Treatment impacts are also significantly larger for enterprises owned by males, and indeed, we find no positive return in enterprises owned by females.

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Which is the tighter constraint on private sector investment: weak property rights or limited access to external finance? From a survey of new firms in post-communist countries, we find that weak property rights discourage firms from reinvesting their profits, even when bank loans are available. Where property rights are relatively strong, firms reinvest their profits; where they are relatively weak, entrepreneurs do not want to invest from retained earnings.