Firm Financing Over the Business Cycle

Data from U.S. public firms show that in booms large firms finance with debt and payout equity, while small firms issue both equity and debt. Therefore, large firms generally substitute between debt and equity financing over the business cycle, whereas small firms' financing policy for debt and equity is procyclical. We propose a novel mechanism to explain these cyclical financing patterns in a heterogeneous firm model with endogenous firm dynamics. We find that cross-sectional differences in investment returns and, therefore, funding needs as well as exposures to financial frictions are essential to understanding how firms' financing policies respond to macroeconomic shocks