Research Articles

Financing Frictions and the Substitution between Internal and External Funds

Heitor Almeidaa1 and Murillo Campelloa2

a1 University of Illinois at Urbana-Champaign, College of Business, 1206 S. 6th St., Champaign, IL 61820, and NBER. halmeida@illinois.edu

a2 University of Illinois at Urbana-Champaign, College of Business, 1206 S. 6th St., Champaign, IL 61820, and NBER. campello@illinois.edu

Abstract

Ample evidence points to a negative relation between internal funds (profitability) and the demand for external funds (debt issuance). This relation has been interpreted as evidence supporting the pecking order theory. We show, however, that the negative effect of internal funds on the demand for external financing is concentrated among firms that are least likely to face high external financing costs (firms that distribute large amounts of dividends, that are large, and whose debt is rated). For firms on the other end of the spectrum (low payout, small, and unrated), external financing is insensitive to internal funds. These cross-firm differences hold separately for debt and equity, and they are magnified in the aftermath of macroeconomic movements that tighten financing constraints. We argue that the greater complementarity between internal funds and external financing for constrained firms is a consequence of the interdependence of their financing and investment decisions.

Footnotes

We thank Mike Faulkender, Murray Frank, João Gomes, Dave Ikenberry, Kathy Kahle, Bob McDonald, Paulo Terra, Mike Weisbach, Jeff Wurgler, Jing Yang, and participants at the 2008 American Finance Association meetings, the 2007 European Financial Management Association Conference, and the 2008 Brazilian Finance Association Meeting, and in particular Hendrik Bessembinder (the editor), Long Chen, Dirk Hackbarth, and Ilya Strebulaev (the referee) for their helpful comments and suggestions. Joongho Han and Marco Rocha provided excellent research assistance. The usual disclaimer applies.

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