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Costly External Finance: Implications for Capital Markets Anomalies

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  • Dongmei Li
  • Lu Zhang

Abstract

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.

Suggested Citation

  • Dongmei Li & Lu Zhang, 2008. "Costly External Finance: Implications for Capital Markets Anomalies," NBER Working Papers 14342, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:14342
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    Cited by:

    1. Long Chen & Lu Zhang, 2009. "The stock market and aggregate employment," NBER Working Papers 15219, National Bureau of Economic Research, Inc.
    2. Yao, Tong & Yu, Tong & Zhang, Ting & Chen, Shaw, 2011. "Asset growth and stock returns: Evidence from Asian financial markets," Pacific-Basin Finance Journal, Elsevier, vol. 19(1), pages 115-139, January.

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    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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