Reinforcing Constraints

59 Pages Posted: 23 Mar 2016 Last revised: 9 Jan 2020

Date Written: June 18, 2019

Abstract

Small firms face financing frictions, and trading their stocks entails non-negligible bid-ask spreads. I develop a model that studies the interconnection between these characteristics and the ensuing effects on corporate policies. The model shows that bid-ask spreads increase not only the cost of external financing but also the cost of internal funds, leading to smaller cash reserves and larger payouts. As a result, firms face tighter financial constraints, higher liquidation risk, underinvestment, and depressed valuations. The model shows that these effects are quantitatively stronger when competitive liquidity providers face participation frictions.

Keywords: Financial constraints, transaction costs, real effects of financial markets, small firms

JEL Classification: G32, G35, G31, G28

Suggested Citation

Zucchi, Francesca, Reinforcing Constraints (June 18, 2019). Available at SSRN: https://ssrn.com/abstract=2750499 or http://dx.doi.org/10.2139/ssrn.2750499

Francesca Zucchi (Contact Author)

Federal Reserve Board ( email )

20th and C Street NW
Washington, DC 20551
United States

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