Preparing for the Storm: Firm Policies and Time-varying Recession Risk

Abstract

How do firms respond to changes in recession risk? We study a rich dynamic model with time-varying recession risk and heterogeneous firm size. In recessions, cash flows decrease, cash-flow volatility increases, external financing becomes unavailable, and liquidation costs increase. Recession risk leads to preemptive equity issuances by low-cash firms, investment cuts by intermediate-cash firms, and payout cuts by highcash firms. Interestingly, large firms’ policies and values co-vary more with changes in recession risk because small firms prepare more when recession risk is low. We provide empirical support for these predictions.