Financial Constraints and the Micro Origins of Aggregate Equity Shocks in Capital Markets

Tobias König

CRC TR 224 Discussion Paper Series from University of Bonn and University of Mannheim, Germany

Abstract: I examine how financial constraints shape the transmission of aggregate external equity financing shocks to firms' equity issuance, outstanding debt, and investment. I construct a novel instrument for aggregate equity financing shocks from firm-level data using the Granular Instrumental Variable (GIV) strategy. I find that financially unconstrained firms--characterized by high cash holdings and dividend-paying status--increase equity issuance by 1.8–2.0 percentage points, substitute equity for debt, and boost investment when capital market conditions improve. Highly leveraged firms, in contrast, refuse both to issue new equity and to reduce outstanding debt, consistent with the leverage ratchet effect. The debt overhang of highly leveraged firms results in 1.9 percentage points lower investment rates compared to the average firm. These results emphasize the crucial role of financial constraints in external equity financing and highlight the broader macroeconomic implications of debt overhang.

Keywords: Capital Markets; External Equity Financing; Granular Instrumental Variable; Financial Constraints (search for similar items in EconPapers)
JEL-codes: E22 E44 G30 G32 (search for similar items in EconPapers)
Pages: 62
Date: 2025-03
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