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Real Effect of Cost of Financing

Real Effect of Cost of Financing


Coauthor(s): Jun Kyung Auh
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Abstract
This paper quantifies the causal effect of borrowing cost on firms’ investment decisions. In an efficient market, investment prospects also affect firms’ borrowing costs. To address potential biases from this reverse causality, I apply an instrumental variable methodology (2SLS-IV), using the regulatory constraints of insurance companies, which are collectively the largest corporate bond investor. In the presence of the capital regulation based on credit ratings, the cross-sectional variation of regulatory constraints across insurance companies creates different selling pressure on their bond holdings upon rating downgrades. This heterogeneity of investors’ risk profiles results in differential shocks to firms’ borrowing costs, and these shocks are orthogonal to firms’ underlying prospects. Using corporate bond data and insurance companies’ bond holding information from 2004-2010, I find that a 1 percentage point of bond spread reduces capital flow of the current period by 12%. Also, my estimates suggest that 5 percentage points of spread increase cut the probability of issuing a new debt by half.

Exact Citation:
Jun Kyung Auh "Real Effect of Cost of Financing." , Columbia Business School, (2013).
Date: 2013