External Equity Financing Shocks, Financial Flows, and Asset Prices
Charles A. Dice Center Working Paper No. 2014-08
59 Pages Posted: 9 May 2014 Last revised: 9 Aug 2017
Date Written: August 5, 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. We show 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, consistent with the model, the model-implied shock in the data 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