Firm Financing over the Business Cycle

Firm financing is the link between financial markets and the real economy. In this paper, we investigate how firm financing depends on the state of the economy. Using Compustat data, we look at the external financing decisions of firms over the business cycle. We find that firm financing is cyclical, but that the cyclicality depends on size. Whereas large firms seem to substitute between debt and equity financing over the business cycle, small firms are unable to do so, increasing financing in good times and reducing it in bad. More importantly, small firms make extensive use of equity financing which is generally more expensive. In this paper, we propose a mechanism that explains these empirical facts in a heterogeneous firm optimization model. Our mechanism is based on two main features: (1) small firms are growing and therefore need more funds and (2) cost of debt financing is higher for more leveraged firms. These features imply that small firms’ funding needs cannot be satisfied by debt alone - especially not in booms when growth opportunities and therefore funding needs are higher. For this reason they turn to equity. The model accounts for the cyclical patterns we see in the data.