We incorporate costly external finance in a production based asset pricing model and investigate whether financing frictions are quantitatively important for pricing a cross-section of expected returns. We show that the common assumptions about the nature of the financing frictions are captured by a simple ‘financing cost’ function, equal to the product of the financing premium and the amount of external finance. This approach provides a tractable framework to examine the role of financing frictions in pricing across-section of asset returns. Using the Generalized Method of Moments (GMM) we estimate a pricing kernel that incorporates the effects of financing constraints on investment behavior. The key ingredients in this pricing kernel depend not only on ‘fundamentals’, such as profits and investment, but also on the financing variables. Our findings, however, suggest that the role played by financing frictions is fairly negligible, unless the premium on external funds is procyclical, a property not evident in the data and not satisfied by most models of costly external finance.
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