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This paper studies the effects of financial policy in a model with heterogeneous agents, incomplete markets and portfolio restrictions. For an economy calibrated to replicate key aspects of the U.S. wealth distribution, we find that the quantitative effects of financial policy are relatively small. The reason is that the households determining aggregate behavior are relatively well insured and can therefore offset the actions of the firm by modifying their portfolio allocations. However, financial policy has important effects on asset prices. Whereas a higher level of debt in the capital structure of the firm introduces more risk into the economy by increasing the volatility of the equity return, it enhances the liquidity of households by increasing the supply of bonds. In an economy with a substantial amount of heterogeneity, this last effect dominates and leverage leads to a decrease in the equity premium. This is in contrast to the findings in representative agent models, in which leverage unambiguously increases the premium through a higher equity return volatility.

The Modigliani–Miller theorem (1958, 1963) on the irrelevance of the firm’s financial policy has been shown to hold in a wide range of environments. In particular, Stiglitz (1969, 1974) extended the partial equilibrium argument developed by the previous authors to a multi-period general equilibrium setup with uncertainty, showing that financial policy is irrelevant for the equilibrium allocations and the value of firms. Moreover, DeMarzo (1988) and Gottardi (1995) showed that this result holds in a more general setting with incomplete financial markets. The previous studies, however, have maintained the convenient assumption of the absence of binding borrowing limits. Given this, they have abstracted from the possibility that financial policy has real effects due to the fact that agents are borrowing constrained. The aim of this paper is to contribute towards filling this gap by providing a quantitative evaluation of the effects of the firm’s financial policy in an environment with incomplete markets, substantial wealth heterogeneity and constraints on borrowing that are effectively binding in equilibrium. This is motivated by two main considerations. First, the friction we study is empirically relevant. The literature documents that there is a fairly high share of borrowing constrained households that ranges between 20% and 30% depending on the assets considered and the type of surveys (see e.g. Jappelli, 1990 or Budria et al., 2002). It is thus important to understand to what extent this interacts with the composition of the capital structure of the firms. For example, by determining the supply of assets though its financial policy, the firm could directly affect the share of households who are at the borrowing constraint.

This paper has studied the effects of leverage in a model with substantial heterogeneity and borrowing constraints which are binding in equilibrium. This friction breaks the irrelevance of financial policy postulated by the traditional Modigliani– Miller proposition. We purposedly assume tight borrowing constraints so as to have a considerable amount of households at the borrowing limits and to give financial policy the highest chance for affecting the equilibrium allocations. Our results illustrate that financial policy does affect the asset prices. Whereas leverage introduces more risk into the economy by increasing the volatility of the equity return, it also enhances the liquidity of households by increasing the supply of bonds in the economy. In the presence of household heterogeneity, however, these two effects almost cancel out. In other words, changing the amount of debt in the capital structure of a leveraged firm does not have a big effect on the equity premium. We also find that leverage affects the portfolio allocations and the number of households that are at the borrowing constraints. However, the agents who determine the behavior of the aggregate laws of motion are relatively well insured and can therefore achieve a very similar consumption profile after the firm changes its financial policy. Given this, the Modigliani–Miller irrelevance proposition holds approximately in these type of economies. It is important to point out that our approach assumes that leverage is taken as given by all agents in the economy, including the firms. It would therefore be interesting to extend the present setting so as to allow for an endogenous determination of the optimal financial policy of the firm. This is an important issue that we leave for further research.