External Equity Financing Shocks, Financial Flows, and Asset Prices

Charles A. Dice Center Working Paper No. 2014-08

Fisher College of Business Working Paper No. 2014-03-08

53 Pages Posted: 9 May 2014 Last revised: 24 Mar 2017

Frederico Belo

University of Minnesota; National Bureau of Economic Research (NBER)

Xiaoji Lin

Ohio State University (OSU) - Fisher College of Business

Fan Yang

University of Connecticut

Multiple version iconThere are 2 versions of this paper

Date Written: March 9, 2017

Abstract

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

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

Frederico Belo

University of Minnesota ( email )

19th Avenue South
Minneapolis, MN 55455
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Xiaoji Lin (Contact Author)

Ohio State University (OSU) - Fisher College of Business ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States

Fan Yang

University of Connecticut ( email )

Storrs, CT 06269-1063
United States

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