33 Pages Posted: 9 May 2001
Date Written: April 2001
Firms that spend the most on capital investments relative to their sales or total assets, subsequently achieve negative benchmark-adjusted returns. We consider two hypotheses to explain these returns. The first explanation, that firms artificially increase cash flows to fund investment expenditures, suggests that the negative relation between returns and investment expenditures should be strongest for the most financially constrained firms. The second explanation, that firms that invest a lot tend to be over-investing, suggests that the negative relation between returns and investment expenditures should be strongest for firms with the most financial slack. The evidence tends to support the second explanation. That is, the negative capital investment/return relation is stronger for firms with higher cash flows and lower debt ratios and reverses in the period when firms of this type were subject to hostile takeovers.
Keywords: Investment, stock returns, financial constraints, free cash flow
JEL Classification: G0, G3
Suggested Citation: Suggested Citation
By Lu Zhang
By Owen Lamont