Financial Frictions and Firm Dynamics

Abstract: Essay 1: In light of the recent Great Recession, it has become painfully clear that financial factors are central to macroeconomic dynamics. This paper evaluates a micro-level financial friction which plays a central role in the theoretical literature on financial frictions, namely the external finance premium. Specifically, the countercyclicality of this premium is tested on the micro-level by identifying firm-specific product demand shocks and then estimating their effects on the firm-specific interest rate. The paper finds robust evidence for a countercyclical external finance premium on the micro-level, suggesting that this is an important mechanism to include in macroeconomic models. Furthermore, the effect seems to be stronger for firms with limited access to internal funds.Essay 2: This paper studies the dynamic impact of product demand shocks on the firm’s capital structure. By identifying firm-specific shocks to product demand, we can estimate a dynamic panel data version of a VAR-model. The estimates are then used to simulate impulse responses describing the firm-level dynamics in key balance sheet variables. We find evidence supporting a sluggish countercyclical adjustment of the debt to equity ratio, which is in line with modern dynamic trade-off theories. Most of the increase in total assets is financed through increased stock of debt and retained earnings. The effect on physical capital is surprisingly weak, while inventories and financial assets react more strongly, causing a hump-shaped reaction in total assets.Essay 3: This paper studies reasons for dividend smoothing by building a model with asymmetric information between the owner and the manager of a firm. The manager's productivity is subject to persistent and stochastic shocks, known only by the manager. Some investments are unobservable to the owner and decided by the manager. The owner has the option of firing the manager at any time and does so if the manager reports a sufficiently bad income state. Having an incomplete wage contract gives the manager an incentive to smooth dividends over different income states at the cost of suboptimal fluctuations in unobservable investments. In some cases, this sub-optimality could be solved by giving the manager a large severance pay.