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Costly External Finance: Implications for Capital Markets Anomalies

  • Dongmei Li
  • Lu Zhang

In a frictionless world, investment is perfectly elastic to changes in the discount rate. With financial frictions, investment is less elastic, meaning that a given magnitude of change in investment is associated with a higher magnitude of change in the discount rate. Equivalently, investment is a more powerful predictor of future stock returns. Consistent with this prediction, we document that the asset growth, external finance, and accrual anomalies in the cross-section of stock returns are much stronger in financially more constrained firms than in financially less constrained firms. Further tests show that this effect of financial constraints is distinct from the effect of financial distress and the effect of limits of arbitrage on the magnitude of the anomalies.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14342.

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Date of creation: Sep 2008
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Handle: RePEc:nbr:nberwo:14342
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