Firm Operating and Financial Responses to a Financial Crisis: 'Maximising Value' while 'Managing for Cash' During a Credit Crunch

Abstract

I develop a model for how heterogeneous firms within an industry respond to a financial shock that temporarily raises the cost of external finance, relative to internally generated funds. The model incorporates three elements that lead to substantial variation across firms in policy response to the shock and affect the time path of aggregate outcomes: endogenous entry, heterogeneity in firm productivity, and gradual scaling up of firm capital stock. I find that these elements lead to firm policies that have off-setting effects on the initial aggregate impact of the crisis, such as the drop in output and investment, but reinforcing effects to slow down the subsequent recovery.

Keywords: Firm and industry dynamics, Financial constraints, Corporate

JEL Classification: G30, L11, O16