Corporate Investment and Financing over the Industry Business Cycle

Abstract

How do firms vary their capital investment and financing policies in response to business cycle fluctuations within their industry? To address this question, we use the regime-switching approach to compute the quarterly time-series of the probability of a future industry downturn for industry groups within the U.S. manufacturing sector. After controlling for the aggregate business cycle, we find that firm-level capital investment and debt issuance are procyclical, whereas net equity issuance and cash accumulation are countercyclical over the industry business cycle. However, there is substantial heterogeneity across firms based on size and credit rating. The effects of the industry business cycle are often larger than that of the aggregate business cycle, and including the former in the analysis changes the relationships between firm-level financing policies and aggregate business cycle documented in previous studies. We show that extending the standard dynamic trade-off model to incorporate heterogeneous effects of industry and aggregate business cycles can help explain the empirical findings.

Keywords: Industry business cycle, capital investment, financing, manufacturing

JEL Classification: E32, G31, G32