Capital Structure over the Business Cycle

Abstract

Why are aggregate equity payouts and debt issued positively correlated over the business cycle in U.S. data? Standard real business cycle (RBC) models have few predictions about capital structure, because they assume that financial markets are frictionless. On the other hand, the tradeoff theory of capital structure argues that financial frictions determine firms' optimal mix of debt and equity financing. We develop an RBC model with financial frictions and use it to explain some stylized facts about aggregate U.S. debt and equity flows. We document that debt issued and equity payouts are (i) positively correlated with output, (ii) positively correlated with investment, and (iii) positively correlated with each other. Our model can account for these stylized facts. We also calibrate the model to the periods 1952-1983 and 1984-2007 in order to explain the finding that real variables have become less volatile in the later subperiod, while financial variables have become more volatile. By varying both the scale of technology shocks and the degree of financial frictions, we are able to account for both results.

Keywords: Debt-equity finance, RBC models, business cycle moderation, corporate finance, capital structure, tradeoff theory, payout policy

JEL Classification: E32, G32, G35