NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Costly External Finance: Implications for Capital Markets Anomalies

Dongmei Li, Lu Zhang

NBER Working Paper No. 14342
Issued in September 2008
NBER Program(s):   AP   CF   EFG

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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This paper was revised on December 5, 2011

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Document Object Identifier (DOI): 10.3386/w14342

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