Working Paper: NBER ID: w12555
Authors: Dmitry Livdan; Horacio Sapriza; Lu Zhang
Abstract: More financially constrained firms are riskier and earn higher expected returns than less financially constrained firms, although this effect can be subsumed by size and book-to-market. Further, because the stochastic discount factor makes capital investment more procyclical, financial constraints are more binding in economic booms. These insights arise from two dynamic models. In Model 1, firms face dividend nonnegativity constraints without any access to external funds. In Model 2, firms can retain earnings, raise debt and equity, but face collateral constraints on debt capacity. Despite their diverse structures, the two models share largely similar predictions.
Keywords: financial constraints; stock returns; risk; expected returns
JEL Codes: G12; G31; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial constraints (H60) | riskier firms (G32) |
| financial constraints (H60) | higher expected returns (G12) |
| riskier firms (G32) | higher expected returns (G12) |
| size and book-to-market ratios (G32) | effect of financial constraints on risk and expected returns (G41) |
| small firms (L25) | financially constrained (D10) |
| less profitable firms (D22) | financially constrained (D10) |
| firms with existing debt (G32) | financially constrained (D10) |
| economic booms (E32) | binding financial constraints (G21) |
| financial gap (G32) | shadow price of external funds (G19) |