External Equity Financing Shocks, Financial Flows, and Asset Prices

The ability of corporations to raise external equity finance varies with macroeconomic conditions, suggesting that the cost of equity issuance is time-varying. Using cross sectional data on U.S. publicly traded firms, we construct an empirical proxy of an aggregate shock to the cost of equity issuance, which we interpret as a financial shock. We show that this shock captures systematic risk, and that exposure to this shock helps price the cross section of stock returns including book-to-market, investment, and size portfolios. We propose a dynamic investment-based model with stochastic equity issuance costs and a collateral constraint to interpret the empirical findings. Our central finding is that time variation in external equity financing costs is important for the model to quantitatively capture the joint dynamics of firms’ asset prices, real quantities, and financing flows. In the model, growth firms, high investment firms, and large firms, can substitute more easily debt financing for equity financing when it becomes more costly to raise external equity, hence these firms are less risky in equilibrium. The model also replicates the failure of the unconditional CAPM in pricing the cross section of stock returns.