Financing Frictions and the Substitution Between Internal and External Funds

36 Pages Posted: 19 Mar 2007 Last revised: 23 Apr 2008

Heitor Almeida

University of Illinois at Urbana-Champaign; National Bureau of Economic Research (NBER)

Murillo Campello

Cornell University; National Bureau of Economic Research (NBER)

Date Written: November 7, 2007

Abstract

There is ample empirical evidence of a negative relation between internal funds (profitability) and the demand for external funds (debt issuance). This negative relation has been interpreted as evidence for external financing costs arising from capital market frictions such as asymmetric information (e.g., the pecking order theory). We show, however, that the negative effect of internal funds on the demand for external financing is concentrated among firms that are \QTR{em}{least likely} to face high costs of external finance (firms that distribute large amounts of dividends, that are large, and whose bonds and commercial papers are rated). For firms in the other end of the spectrum (low payout, small, and unrated), external financing is insensitive to innovations to internal funds. These cross-firm differences hold separately for debt and outside equity financing, and are magnified in the aftermath of macroeconomic movements that tighten financial constraints. We argue that the greater degree of complementarity between internal funds and external finance for constrained firms is a consequence of the interdependence of their financing and investment decisions. Our findings suggest that the negative relation between internal funds and external financing should not be interpreted as evidence for external financing costs.

Keywords: Capital structure, external financing, pecking order, financial constraints, investment, GMM, business cycles

JEL Classification: G31

Suggested Citation

Almeida, Heitor and Campello, Murillo, Financing Frictions and the Substitution Between Internal and External Funds (November 7, 2007). AFA 2008 New Orleans Meetings Paper. Available at SSRN: https://ssrn.com/abstract=970996 or http://dx.doi.org/10.2139/ssrn.970996

Heitor Almeida

University of Illinois at Urbana-Champaign ( email )

515 East Gregory Drive
4037 BIF
Champaign, IL 61820
United States
217-3332704 (Phone)

HOME PAGE: http://www.business.illinois.edu/FacultyProfile/faculty_profile.aspx?ID=11357

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Murillo Campello (Contact Author)

Cornell University ( email )

114 East Avenue
369 Sage Hall
Ithaca, NY 14853
United States

HOME PAGE: http://www.johnson.cornell.edu/Faculty-And-Research/Profile.aspx?id=mnc35

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138

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