Liquidity, Information Production, and Debt-Equity Choice

We show that stock liquidity increases the propensity of firms to raise debt capital. The positive effect of liquidity on a debt issuance propensity is much stronger in firms with greater default risk. The effect of liquidity on the cost of debt capital is much larger than its effect on the cost of equity capital. These results are consistent with standard theoretical frameworks for financing under uncertainty and asymmetric information: by facilitating information production, stock liquidity reduces insider and market uncertainty about future firm cash flows, thereby lowering the default risk and thus the costs of debt financing.