Why Does Capital Structure Choice Vary with Macroeconomic Conditions?

Abstract

This paper develops a calibrated model that explains the pronounced counter-cyclical leverage patterns observed for firms that access public capital markets, and relates these patterns to debt and equity issues. Moreover, it explains why leverage and debt issues do not exhibit this pronounced behavior for firms that face more severe constraints when accessing capital markets. In the model, managers issue a combination of debt and equity to finance investment by weighting the trade-off between agency problems and risk sharing. During contraction, leveraged managers receive a relatively small share of wealth, resulting in a relative increase in household demand for securities. Securities markets clear as managers that are not up against their borrowing constraints increase leverage while satisfying the agency condition that they maintain a large enough portion of their firm's equity.