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The Joint Dynamics of Internal and External Finance

Author

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  • Tyler Muir

    (Northwestern University)

  • Andrea Eisfeldt

    (UCLA Anderson School of Management)

Abstract

We document the fact that at both the aggregate and the firm level, corporations tend to simultaneously raise external finance and accumulate liquid assets. For all but the very largest firms, the aggregate correlation between external finance raised and liquidity accumulation is 0.6, and the average firm level correlation is 0.2. This seems puzzling if internal and external finance are substitutes and external finance is costly. In fact, static pecking order intuition predicts that firms will first draw down liquid balances and only then issue external finance. On the other hand, if one believes that the cost of external finance varies over time, then the fact that there appear to be aggregate waves of issuance and savings activity may not be surprising. We show that a simple dynamic model with constant costs of external finance can easily match the observed positive correlation between liquidity accumulation and external finance. We compare the results of this simple model to those from a model which features a shock to the cost of external finance.

Suggested Citation

  • Tyler Muir & Andrea Eisfeldt, 2012. "The Joint Dynamics of Internal and External Finance," 2012 Meeting Papers 842, Society for Economic Dynamics.
  • Handle: RePEc:red:sed012:842
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