The Role of Debt and Equity Finance over the Business Cycle

64 Pages Posted: 19 May 2008

See all articles by Francisco Covas

Francisco Covas

Bank of Canada

Wouter J. den Haan

University of Amsterdam; Centre for Economic Policy Research (CEPR); Tinbergen Institute

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

Covas, Francisco and Den Haan, Wouter J., The Role of Debt and Equity Finance over the Business Cycle (February 2007). CEPR Discussion Paper No. DP6145, Available at SSRN: https://ssrn.com/abstract=1133790

Francisco Covas (Contact Author)

Bank of Canada ( email )

234 Wellington Street
Ottawa, Ontario K1A 0G5
Canada

Wouter J. Den Haan

University of Amsterdam ( email )

Spui 21
Amsterdam, 1018 WB
Netherlands

HOME PAGE: http://www1.feb.uva.nl/toe/content/people/content/denhaan/pers.htm

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

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