The Effect of Stock Liquidity on the Firm's Investment and Production

Abstract

We show that stock market liquidity affects subsequent corporate investment and production. Stock illiquidity, which raises the firm’s cost of capital, lowers investment in capital assets, R&D, and inventory. This effect holds regardless of the firms’ financially constraints. Consequently, illiquidity induces firms to adopt production processes that are less capital intensive. Illiquid firms have higher marginal productivity of capital, greater labor input increase for given increases in assets, and lower operating leverage, thus being less reliant on fixed costs. These effects hold after controlling for endogeneity, employing an exogenous liquidity event – the 2001 decimalization – and the instrumental variable method.

Keywords: liquidity, investment, production