A Corporate Financing-Based Asset Pricing Model

I show that an asset pricing model for the equity claims of a value-maximizing firm can be constructed from its optimal financial contracting behavior. I study a dynamic contracting model in which firms trade off the costs and benefits of a given promise to pay external lenders in a specific economic state. Deals between firms and financiers reveal the importance of that state for firm's equity value, namely the stochastic discount factor the firm responds to. I empirically evaluate the model in the cross section of expected equity returns. I find that the financial contracting approach goes a long way in rationalizing observed cross-sectional differences in average returns, also in comparison to leading asset pricing models. In addition, the model discloses that two easily measured variables, the growth rates on net worth and profitability, generate sizeable cross-sectional spreads in returns. Finally, a calibrated version of the model is broadly consistent with observed corporate policies of US listed firms.