Financing Decisions, Capital Expenditures, and the Effect of Favoritism

• In Event: Intersections of accounting and finance

Abstract

The literature has found long-term negative future stock returns related to two corporate decisions: external financing and capital expenditures. Researchers have surmised that market timing and empire building, respectively, are the root causes of these negative returns. Using a firm-level measure of investor ‘favoritism,’ we provide insight into the mechanisms underlying these anomalies and the managerial intent behind the related financing and investment decisions. We find that both a firm’s external financing and capital expenditures decisions are positively (negatively) associated with the favoritism (neglect) of the stock by investors. Consistent with past conjectures, we find that the negative association between future stock returns and external financing is even more pronounced in periods of favoritism, consistent with the notion that managers exploit investor favoritism and perceive it as irrational overpricing. However, we find that the association between future stock returns and capital expenditures becomes positive in periods of favoritism, which is inconsistent with past conjectures that capital expenditures simply reflect empire building by managers. Rather, it suggests that managers’ private information and investors’ perceptions are aligned; i.e., managers invest in positive net present value capital expenditures. Further, there is no longer a relation between capital expenditures and future stock returns after controlling for favoritism and external financing. This paper responds to calls by Kothari (2001) and Lee (2001) to provide explanations for anomalies and understanding of the mechanisms that create market inefficiencies.

Authors

• Lucile C Faurel, Arizona State University

• Mark T Soliman, University of Southern California

• Jessica C Watkins, Indiana University - Bloomington

• Teri Lombardi Yohn, Indiana University - Bloomington