How Costly is External Financing ? Evidence from a Structural Estimation

We apply simulated method of moments to a dynamic model to infer the magnitude of financing costs. The model features endogenous investment, distributions, leverage, and default. The corporation faces taxation, costly bankruptcy, and linear-quadratic equity flotation costs. For large (small) firms, estimated marginal equity flotation costs start at 5.0% (10.7%) and bankruptcy costs equal to 8.4% (15.1%) of capital. Estimated financing frictions are higher for low-dividend firms and those identified as constrained by the Cleary and Whited-Wu indexes. In simulated data, many common proxies for financing constraints actually decrease when we increase financing cost parameters. ∗Christopher Hennessy is at the University of California, Berkeley, and Toni Whited is at the University of Wisconsin, Madison. An earlier version of this paper was circulated under the title, “Beyond Investment-Cash Flow Sensitivities: Using Indirect Inference to Estimate Costs of External Funds.” We thank seminar participants at Carnegie Mellon University, University of Southern California, Kellogg, University of Colorado, University of Texas at Austin, University of Illinois, New York University, University of Maryland, Rochester, the Stockholm Institute for Financial Research, Instituto Tecnológico Autónomo de México, the University of British Columbia Summer Finance Conference, the Western Finance Association Annual Meetings, and the European Finance Association Annual Meetings. Special thanks to Lisa Kramer, Nathalie Moyen, Michael Roberts, an associate editor, and two anonymous referees for detailed feedback. Corporate finance is primarily the study of financing frictions. After all, Modigliani and Miller (1958) showed that a CFO can neither create nor destroy value through his financing decisions in a world without such frictions. There is little debate about the existence of market imperfections that drive a wedge between the cost of internal and external funds, with a voluminous theoretical literature buttressing the argument that external funds are costly. However, the magnitude of financing frictions is still an open question. Empirical researchers have employed an array of methods to gauge the magnitude of financing frictions. For example, Altinkilic and Hansen (2000) estimate underwriter fee schedules. Asquith and Mullins (1986), amongst many others, measure the indirect costs of external equity by studying announcement effects. Weiss (1990) measures the direct legal costs incurred during Chapter 11 bankruptcies. Andrade and Kaplan (1998) assess the indirect costs of financial distress in a sample of highly levered transactions that became distressed. Another set of studies, for example, Fazzari et al. (1988), attempts to gain a sense of the magnitude of financial frictions using reduced-form investment regressions. In this paper we use observed corporate financing choices in order to infer the magnitude of financing frictions by exploiting simulated method of moments (SMM). We begin by formulating a dynamic structural model of optimal financial and investment policy for a firm facing a broad set of frictions: Corporate and personal taxation, bankruptcy costs, and linear-quadratic costs of external equity. In addition, the model embeds an agency cost of debt, as the equity-maximizing manager underinvests relative to first-best. Parameters describing the firm’s production technology, profitability shocks, and financing costs represent unknowns in the structural model. Of particular interest are the four financing cost parameters, namely, bankruptcy costs as a percentage of capital and three constants in a linear-quadratic cost of external equity function. Under conditions discussed below, minimizing the distance between model-generated moments and real-world moments yields consistent estimates of the unknown parameters. Less formally, one can view the estimates as answering the following question: What magnitude of financing costs “best” explains observed financing and investment patterns? An important step in the SMM procedure involves selecting the moments to be matched. In this