Figure 8
1 Average model-implied recovery rate with μ = 0, weighted by the book value of bonds outstanding.
2 Average model-implied recovery rate with estimated μ , weighted by the book value of bonds
outstanding.
3 Average recovery rate at default weighted by the book value of the defaulted bond issue
(four-quarter moving average).
cyclically, amplifying the swings in borrowing and, consequently, in investment and
output.
Figure 9 shows the cyclical behavior of the model-implied external finance pre-
mium calculated using the solutions for ω*t and σ*t and our estimates of the bankruptcy
cost parameter μt. Smoothing through the Russian default in late 1998, the model-
implied external finance premium was close to zero across the entire cross-section of
firms until the end of 1999. As stock prices began to slide in early 2000, causing a
decline in firms’ net worth (i.e., market capitalization) and an increase in corporate
leverage, the external finance premium rose sharply, and the increase is economically
significant. Firms that account for a half of aggregate sample sales experienced an
increase in the external finance premium of at least 150 basis points, while firms that
account for one quarter of aggregate sample sales faced an increase in the external fi-
nance premium of more than 300 basis points. The external finance premium started
to decline at the end of the NBER-date recession but then jumped up again at the
end of 2002 in response to concerns about corporate governance.
To investigate the interaction between the cyclical behavior of our estimates of
μ and the dynamics of the external finance premium over the latest business cycle,
27