The Mechanisms Underlying External Financing and Capital Expenditures: Insights from Firm-Level Optimism/Pessimism

44 Pages Posted: 31 Aug 2018 Last revised: 20 May 2019

See all articles by Lucile Faurel

Lucile Faurel

Arizona State University

Mark T. Soliman

University of Southern California - Marshall School of Business

Jessica Watkins

University of Notre Dame

Teri Lombardi Yohn

Indiana University - Kelley School of Business - Department of Accounting

Date Written: May 16, 2019

Abstract

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 et al. 2004) is primarily driven by external financing decisions.

Keywords: External financing, capital expenditures, mispricing, optimism, favoritism.

JEL Classification: D24, G31, M41

Suggested Citation

Faurel, Lucile and Soliman, Mark T. and Watkins, Jessica and Yohn, Teri Lombardi, The Mechanisms Underlying External Financing and Capital Expenditures: Insights from Firm-Level Optimism/Pessimism (May 16, 2019). Kelley School of Business Research Paper No. 18-75. Available at SSRN: https://ssrn.com/abstract=3237123 or http://dx.doi.org/10.2139/ssrn.3237123

Lucile Faurel

Arizona State University ( email )

W.P. Carey School of Business
School of Accountancy, B267H
Tempe, AZ 85287
United States
(480) 965-6216 (Phone)

Mark T. Soliman

University of Southern California - Marshall School of Business ( email )

2250 Alcazar Street
Los Angeles, CA 90089
United States

Jessica Watkins

University of Notre Dame ( email )

384 Mendoza College of Business
Notre Dame, IN 46656
United States

Teri Lombardi Yohn (Contact Author)

Indiana University - Kelley School of Business - Department of Accounting ( email )

1309 E. 10th Street
Bloomington, IN 47405
United States
(812) 855-0430 (Phone)

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