Corporate Investment and Asset Price Dynamics: Implications for the Cross-Section of Returns

Abstract:     
We show that corporate investment decisions can explain conditional dynamics in expected asset returns. Our approach is similar in spirit to Berk, Green, and Naik (1999), but we introduce to the investment problem operating leverage, reversible real options, fixed adjustment costs, and finite growth opportunities. We assume constant revenue betas, but still obtain asset betas that vary through time as a reflection of historical investment decisions and product market demand. Book-to-market effects emerge and relate to operating leverage, while size captures the importance of growth options relative to assets in place. We first develop these results in a simple setting that permits closed-form solutions. Next, we empirically evaluate a more realistic specification that is solved numerically and estimated using simulated method of moments. This provides new quantitative evidence on the importance of
operating leverage and growth options to the cross-section of returns.

Number of Pages in PDF File: 37

Keywords: Cross-Section of Returns, Size Effect, Book-to-Market Effect, Corporate Investment, Real Options, Simulated Method of Moments

JEL Classification: G12

working papers series