The Business Cycle, Investor Sentiment, and Costly External Finance




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    • McLean is from the University of Alberta and MIT. Zhao is from the University of Alberta. We owe special thanks to Campbell Harvey (the Editor), an anonymous Associate Editor, and an anonymous referee for helpful comments and guidance. We also thank Michael Cooper, Ying Duan, Randall Morck, Chris Parsons, Sukesh Patro, Jeffrey Pontiff, Liz Tashjian, seminar participants at the University of Alberta, the University of Arizona, and the University of Utah, and conference participants at the French Finance Association, the Academy of Behavioral Finance and Economics, and the Queens School of Business Behavioral Finance Conference for helpful comments. We thank the Social Sciences and Humanities Research Council of Canada for financial support.


The recent financial crisis shows that financial markets can impact the real economy. We investigate whether access to finance typically time-varies and, if so, what are the real effects. Consistent with time-varying external finance costs, both investment and employment are less sensitive to Tobin's q and more sensitive to cash flow during recessions and low investor sentiment periods. Share issuance plays a bigger role than debt issuance in causing these effects. Alternative tests that do not rely on q and cash flow sensitivities suggest that recessions and low sentiment increase external finance costs, thereby limiting investment and employment.