A Business Cycle Analysis of Debt and Equity Financing

This article provides an introductory, yet comprehensive, business cycle analysis of firm financing. Using data from Compustat, we find that debt issuance is procyclical while the net sale of stock is countercyclical. However, an equity financing measure that includes stock compensation and especially mergers turns out to be weakly procyclical. Nevertheless, there is widespread heterogeneity in firm financing. Compared to large firms, the equity issuance of small firms tends to be more procyclical while debt issuance tends to be less procyclical. We then examine how well a quantitative model of firm financing can match the cyclical properties of debt and equity issuance. In our model, heterogeneous firms choose an optimal capital structure by balancing the tax benefits and bankruptcy costs of debt issuance with the costs associated with equity issuance. The model generates a procyclical debt and countercyclical equity issuance. Moreover, the model can match the firm-size relationship regarding debt and especially equity issuance.