The Mechanisms Underlying External Financing and Capital Expenditures: Insights from Firm-Level Optimism/Pessimism
45 Pages Posted: 31 Aug 2018 Last revised: 15 Oct 2019
Date Written: October 14, 2019
Prior literature documents a positive (negative) relation between past (future) stock returns and both external financing and capital expenditures. There has been much debate in the literature regarding the mechanisms driving these relations. In this study, we provide insights into these mechanisms by examining the effect of firm-level overpricing (underpricing) due to investor optimism (pessimism) on managers’ external financing and capital expenditure decisions and the associated future stock returns. We rely on the “favoritism” (“neglect”) proxy developed by Lee and Swaminathan (2000), which incorporates both a stock’s return momentum and trading volume, to capture firm-level overpricing (underpricing) due to investor optimism (pessimism). After controlling for stock return momentum, growth opportunities, and improvements in fundamentals, we find that favoritism (neglect) is positively (negatively) associated with external financing decisions, and that the previously documented negative association between external financing and future stock returns is more pronounced in periods of favoritism. In contrast, after controlling for external financing, the positive (negative) association between favoritism (neglect) and capital expenditure decisions is attenuated, and we do not find a negative relation between capital expenditures and future stock returns. These findings suggest that financing decisions, but not capital expenditure decisions, are likely associated with managers’ exploitation of investor mispricing due to investor optimism/pessimism toward the stock. These findings also suggest the previously documented negative relation between capital expenditures and future stock returns (e.g., Titman, Wei, and Xie 2004) is primarily driven by external financing decisions.
Keywords: external financing, capital expenditures, mispricing, optimism, favoritism
JEL Classification: D24, G31, M41
Suggested Citation: Suggested Citation