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Capital Market Imperfections and the Sensitivity of Investment to Stock Prices

Alexei V. Ovtchinnikov

HEC Paris - Finance Department

John J. McConnell

Purdue University

July 10, 2007

Prior studies argue that investment by undervalued firms that require external equity is particularly sensitive to stock prices in irrational capital markets. We present a model in which investment can appear to be more sensitive to stock prices when capital markets are rational, but subject to imperfections such as debt overhang, information asymmetries, and financial distress costs. Our empirical tests support the rational (but imperfect) capital markets view. Specifically, investment-stock price sensitivity is related to firm leverage, financial slack, and probability of financial distress, but is not related to proxies for firm undervaluation. Because, in our model, stock prices reflect the NPVs of investment opportunities, our results are consistent with rational capital markets improving the allocation of capital by channeling more funds to firms with positive NPV projects.

Number of Pages in PDF File: 46

Keywords: Investment policy, financing policy, capital market imperfections

JEL Classification: G12, G14, G31, G32

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Date posted: February 17, 2005  

Suggested Citation

Ovtchinnikov, Alexei V. and McConnell, John J., Capital Market Imperfections and the Sensitivity of Investment to Stock Prices (July 10, 2007). Available at SSRN: https://ssrn.com/abstract=668522 or http://dx.doi.org/10.2139/ssrn.668522

Contact Information

Alexei V. Ovtchinnikov (Contact Author)
HEC Paris - Finance Department ( email )
1 rue de la Liberation
Jouy-en-Josas Cedex, 78351

John J. McConnell
Purdue University ( email )
403 West State St.
West Lafayette, IN 47907-2056
United States
765-494-5910 (Phone)
765-494-7863 (Fax)
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