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The Role of Debt and Equity Finance over the Business Cycle

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  • Francisco Covas
  • Wouter J. den Haan

Abstract

The authors show that debt and equity issuance are procyclical for most listed U.S. firms. The procyclicality of equity issuance decreases monotonically with firm size. At the aggregate level, however, the authors' results are not conclusive: issuance is countercyclical for very large firms that, although few in number, have a large effect on the aggregate because of their enormous size. If firms use the standard one-period contract, then the shadow price of external funds is procyclical and the cyclicality decreases with firm size. This property generates equity to be procyclical and--as in the data--the procyclicality decreases with firm size. Other factors that cause equity to be procyclical in the model are a countercyclical price of risk and a countercyclical cost of equity issuance. The model (i) generates a countercyclical default rate, (ii) magnifies shocks, and (iii) generates a stronger cyclical response for small firms, whereas the model without equity does the exact opposite.

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Bibliographic Info

Paper provided by Bank of Canada in its series Working Papers with number 06-45.

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Length: 65 pages
Date of creation: 2006
Date of revision:
Handle: RePEc:bca:bocawp:06-45

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Keywords: Financial stability; Business fluctuations and cycles;

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References

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