Data from U.S. public firms show that in booms large firms finance with debt and payout equity, whereas small firms issue both equity and debt. Therefore, large firms generally substitute between debt and equity financing over the business cycle, whereas small firms adhere to a procyclical financing policy for debt and equity. We explain these cyclical financing patterns quantitatively using a heterogeneous firm model with endogenous firm dynamics. We find that cross-sectional differences in investment returns and, therefore, funding needs and exposures to financial frictions are essential to understanding how firms' financing policies respond to macroeconomic shocks.
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We are deeply indebted to Monika Piazzesi, Martin Schneider, Manuel Amador, and Pablo Kurlat for their invaluable guidance. We also want to thank our discussants Lukas Schmid, Toni Whited, Cecilia Parlatore, and Vincenzo Quadrini for their insights. The paper benefited from conversations with Frederico Belo, Simon Gilchrist, Joao Gomes, Ellen McGrattan, and Amir Yaron and comments from participants at the FRB San Francisco, AFA 2016, the NBER Capital Market Summer Institute 2015, the Junior Faculty Research Roundtable at UNC 2015, Boston University, the UBC 2015 Winter conference, University of Minnesota, the 2014 Johnson Corporate Finance Conference, the Society of Economic Dynamics 2014 in Toronto, and Stanford. We thank Youngmin Kim for excellent research assistance. The authors gratefully acknowledge support from the Kohlhagen Fellowship Fund and the Haley-Shaw Fellowship Fund of the Stanford Institute for Economic Policy Research (SIEPR). J. B. is grateful for support from a Macro Financial Modeling Group dissertation grant from the Alfred P. Sloan Foundation. Supplementary data can be found on The Review of Financial Studies Web site. Send correspondence to Juliane Begenau, Stanford University, 655 Knight Way, Stanford, 94305; telephone: (650)724-5661. E-mail: firstname.lastname@example.org.
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