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The role of debt and equity finance over the business cycle

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  • Francisco Covas
  • Wouter Denhaan

    ()
    (Economics Subject Area London School of Economics)

Abstract

Net equity issuance occurs frequently and is quantitatively important for both small and large publicly traded firms. Moreover, we show that net equity and net debt issuance are positively correlated and both are procyclical for small firms. For large firms net equity issuance is neither cyclical nor correlated with debt issuance. We extend the existing business cycle models with agency costs in two ways. First, we relax the standard assumptions of linearity and full depreciation. Consequently, variables such as the default probability and leverage will depend on firm size. It also means that an increase in net worth reduces the default probability (instead of leaving it unchanged). Second, we relax the standard assumption that firms cannot attract outside equity. In our model, aggregate shocks are propagated as in the model without equity issuance, but in contrast to the standard model they are also magnified and the default rate is countercyclical. Moreover, our model is consistent with the observed cyclical behavior of firms' financing sources for both small and large firms.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number 407.

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Date of creation: 03 Dec 2006
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Handle: RePEc:red:sed006:407

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Keywords: agency costs; frictions;

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