Equity Financing Risk

55 Pages Posted: 21 Dec 2017 Last revised: 31 Jan 2019

See all articles by Mamdouh Medhat

Mamdouh Medhat

Dimensional Fund Advisors

Berardino Palazzo

Board of Governors of the Federal Reserve System

Multiple version iconThere are 2 versions of this paper

Date Written: January 30, 2019

Abstract

We develop a model of equity financing risk (EFR; i.e., risky equity issuance costs) to study the joint effects of precautionary savings and research and development (R&D) investments on expected returns. Our evidence confirms the model: (1) financial slack (i.e., liquid assets relative to R&D) lowers EFR exposure and thereby expected returns, (2) equity issuance lowers expected returns by increasing financial slack, and (3) these effects are concentrated among unprofitable firms. Moreover, an EFR factor yields a premium of 1.45% per month (t = 4.80), subsumes the Fama-French (2015) and Hou-Xue-Zhang (2015) investment factors, and helps explain anomalies related to R&D and cash-based operating profitability.

Keywords: Equity returns, R&D, financing constraints, equity issuances, factor models

JEL Classification: G12, G31, G35

Suggested Citation

Medhat, Mamdouh and Palazzo, Berardino, Equity Financing Risk (January 30, 2019). Available at SSRN: https://ssrn.com/abstract=3089792 or http://dx.doi.org/10.2139/ssrn.3089792

Mamdouh Medhat

Dimensional Fund Advisors ( email )

6300 Bee Cave Road, Building One
Austin, TX 78746
United States

HOME PAGE: http://https://sites.google.com/site/mamdouhmedhatresearch/home

Berardino Palazzo (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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