Firm Financing Over the Business Cycle

In the data, large public firms substitute between debt- and equity financing over the business cycle whereas small firms' financing policy is pro-cyclical for debt and equity. This paper proposes a mechanism that explains these cyclical patterns. Small firms grow faster and need therefore more funds compared to large firms. During times with high aggregate productivity, they quickly exhaust their endogenous debt limit and must turn to equity financing. In contrast, large firms are close to their efficient scale and want to payout to shareholders. Good times lower the probability of default, decreasing the costs of debt financing for large firms so that debt is used to payout to shareholders. We embed this mechanism in a quantitative firm industry model with endogeneous firm dynamics and explore how macroeconomic shocks get amplified.