This paper studies the cyclical properties of capital reallocation and the frictions which inhibit such reallocation. We show that the amount of capital reallocation and the benefits to reallocation vary at the business cycle frequency. The amount of capital reallocation is procyclical. In contrast, the benefits to capital reallocation appear countercyclical. We measure the amount of reallocation using data on flows of capital across firms and the benefits to capital reallocation using several measures of the cross sectional dispersion of the productivity of capital. We then study a calibrated model of an economy where capital reallocation is costly and impute the cost of reallocation which is consistent with the amount of and benefits to reallocation in the data. We find that the cost of reallocation needs to be substantially countercyclical to be consistent with the observed joint cyclical properties of reallocation and productivity dispersion. The cyclical variation in this cost is interpreted as variation in the liquidity of capital, broadly defined, since physical costs are unlikely to vary countercyclically.

Collateral constraints imply that financing and risk management are fundamentally linked. The opportunity cost of engaging in risk management and conserving debt capacity to hedge future financing needs is forgone current investment, and is higher for more productive and less well-capitalized firms. More constrained firms engage in less risk management and may exhaust their debt capacity and abstain from risk management, consistent with empirical evidence and in contrast to received theory. When cash flows are low, such firms may be unable to seize investment opportunities and be forced to downsize. Consequently, capital may be less productively deployed in downturns.Financing and risk management are fundamentally linked as both involve promises to pay that are limited by collateral constraints. Engaging in risk management and conserving debt capacity have an opportunity cost -current investment is forgone. This cost is higher for more constrained firms. This insight has important implications for the extent of corporate risk management.

This paper studies the financing role of leasing and secured lending. We argue that the benefit of leasing is that repossession of a leased asset is easier than foreclosure on the collateral of a secured loan, which implies that leasing has higher debt capacity than secured lending. However, leasing involves agency costs due to the separation of ownership and control. More financially constrained firms value the additional debt capacity more and hence lease more of their capital than less constrained firms. We provide empirical evidence consistent with this prediction. Our theory is consistent with the explanation of leasing by practitioners, namely that leasing "preserves capital," which the academic literature considers a fallacy.