Charles A. Dice Center Working Paper No. 2014-08
53 Pages Posted: 9 May 2014 Last revised: 24 Mar 2017
Date Written: March 9, 2017
The ability of corporations to raise external equity ﬁnancing varies with macroeconomic conditions. We develop a dynamic model economy with external equity ﬁnancing frictions to evaluate the impact of variation of the aggregate cost of equity issuance on ﬁrms’ asset prices and ﬁnancing policies. 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 ﬁnancial ﬂows. In the model, growth ﬁrms and high investment ﬁrms can substitute more easily debt ﬁnancing for equity ﬁnancing when it becomes more costly to raise external equity, which tend to occur at times when marginal utility is high. 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. Guided by the theory, we construct an empirical proxy of the aggregate shock to the cost of equity issuance using cross sectional data on U.S. publicly traded ﬁrms. We show that the model-implied shock captures systematic risk, and that exposure to this shock helps price the cross section of stock returns of book-to-market, investment, and industry portfolios.
Keywords: Issuance shocks, asset pricing, book-to-market, investment, costly external financing, collateral constraint
JEL Classification: E23, E44, G12
Suggested Citation: Suggested Citation
Belo, Frederico and Lin, Xiaoji and Yang, Fan, External Equity Financing Shocks, Financial Flows, and Asset Prices (March 9, 2017). Charles A. Dice Center Working Paper No. 2014-08; Fisher College of Business Working Paper No. 2014-03-08. Available at SSRN: https://ssrn.com/abstract=2434156 or http://dx.doi.org/10.2139/ssrn.2434156