Beyond Investment-Cash Flow Sensitivities: Using Indirect Inference to Estimate Costs of External Funds

44 Pages Posted: 2 Mar 2005

See all articles by Chris Hennessy

Chris Hennessy

London Business School

Toni M. Whited

University of Michigan, Stephen M. Ross School of Business; National Bureau of Economic Research

Date Written: November 2004

Abstract

This paper estimates costs of external finance, applying indirect inference to a dynamic structural model where the corporation endogenously chooses investment, distributions, lever ageand default. The corporation faces double taxation, costly state verification indebt markets, and linear-quadratic costs of external equity. Consistent with direct evidence on under writer fee schedules, behavior is best explained by rising marginal costs of external equity, starting at 3.9%. Contrary to the notion that corporations are debt conservative, leverage is consistent with small (12.2%) bankruptcy costs. Investment-cash flow sensitivities are not a sufficient statistic for financing costs. The cash flow coefficient decreases in external equity costs and increases in bankruptcy costs. When the model is simulated using our parameter estimates, the cash flow coefficient across Fazzari, Hubbard, and Petersen's dividend classes is U-shaped. The difference between cash flow coefficients across dividend classes actually decreases as costs are increased.

Keywords: Investment, indirect inference, finance constraints

JEL Classification: G31, G32, G35,E22

Suggested Citation

Hennessy, Christopher and Whited, Toni M., Beyond Investment-Cash Flow Sensitivities: Using Indirect Inference to Estimate Costs of External Funds (November 2004). EFA 2005 Moscow Meetings Paper. Available at SSRN: https://ssrn.com/abstract=676015 or http://dx.doi.org/10.2139/ssrn.676015

Christopher Hennessy

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Toni M. Whited (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

National Bureau of Economic Research ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
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