Empirical Evidence on Capital Investment, Growth Options, and Security Returns

Abstract:     
The model and simulations of Berk, Green, and Naik (BGN, 1999) suggest that exercise of growth options alters firm-specific characteristics such as firm size (MVE) and book-to-market ratio (B/M) commensurately with changes in systematic risk. Consistent with BGN, we show empirically that classification of firms to MVE and B/M portfolios as in Fama and French (1992, 1993) is conditioned on recent growth in capital expenditures. Specifically, firms classified as big and low-B/M (B/L) significantly accelerate investment prior to the classification year. In contrast, firms classified as small and high-B/M (S/H) reduce investment. We also find that stock returns vary inversely with prior investment growth, that the value premium diminishes after categorizing stocks by investment growth, and that variables based on growth in capital expenditures explain stock returns in cross-section and portfolio returns in times series. These empirical results are consistent with the notion that exercise of growth options affects firm-specific characteristics such as MVE and B/M and exposure to systematic risk.

Number of Pages in PDF File: 38

Keywords: Expected returns, Book-to-market, Size effect, Anomalies, Capital investment

JEL Classification: G12, G31

working papers series