Under revision for the Review of Financial Studies
We study the investment and financing policies of public U.S. firms. Large firms substitute between debt- and equity financing over the business cycle whereas small firms’ financing policy for debt and equity is pro-cyclical. This paper proposes a novel mechanism that explains these cyclical patterns in a quantitative heterogeneous firm industry model with endogenous firm dynamics. We find that cross-sectional differences in investment policies and therefore funding needs as well as exposure to financial frictions are key to understand how firms’ financing policies respond to macroeconomic shocks. Financial frictions cause firms to be larger with lower valuations and less investments.