The Role of Debt and Equity Finance over the Business Cycle
64 Pages Posted: 19 May 2008
Date Written: February 2007
Abstract
This paper documents that debt and equity issuance are procyclical for most size-sorted firm categories of listed U.S. firms. The procyclicality of equity issuance decreases monotonically with firm size. At the aggregate level, however, the results are not conclusive. The reason is that issuance is countercyclical for very large firms which, although few in number, have a large effect on the aggregate because of their enormous size. We show that the shadow price of external funds is procyclical if firms use the standard one-period contract. This model property generates procyclical equity and - as in the data - the procyclicality decreases with firm size. Another factor that causes equity to be procyclical in the model is a countercyclical cost of equity issuance. The calibrated model (i) generates a countercyclical default rate, (ii) generates a stronger cyclical response for small firms, and (iii) magnifies shocks, whereas the model without equity as an external financing source does the exact opposite.
Keywords: Agency problems, firm heterogeneity, magnification
JEL Classification: E32, E44
Suggested Citation: Suggested Citation
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