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

Abstract

We propose that stock market liquidity affects corporate investment and production decisions. Illiquidity raises the required return and the firm’s cost of capital and thus negatively affects investment in fixed assets, in R&D and in inventory. The negative investment-illiquidity relation holds even for firms that are not financially constrained. Consequently, illiquidity induces firms to adopt a production process that is less capital intensive. Illiquid firms have higher marginal productivity of capital, more labor input for a given increase in capital, and lower operating leverage that means a lesser reliance on fixed costs. These effects hold after controlling for endogeneity by the instrumental variables method and for an exogenous liquidity event, the 2001 decimalization.

Keywords: liquidity, investment, production