Reinforcing Constraints

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