Asset Pricing Implications of Firms' Financing Constraints
58 Pages Posted: 6 Dec 2002 Last revised: 30 Oct 2010
Date Written: December 2002
We incorporate costly external finance in an investment-based asset pricing model and investigate whether financing frictions are quantitatively important for pricing a cross-section of expected returns. We show that common assumptions about the nature of the financing frictions are captured by a simple financing cost' function, equal to the product of the financing premium and the amount of external finance. This approach provides a tractable framework for empirical analysis. Using GMM, we estimate a pricing kernel that incorporates the effects of financing constraints on investment behavior. The key ingredients in this pricing kernel depend not only on fundamentals', such as profits and investment, but also on the financing variables, such as default premium and the amount of external financing. Our findings, however, suggest that the role played by financing frictions is fairly negligible, unless the premium on external funds is procyclical, a property not evident in the data and not satisfied by most models of costly external finance.
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