SSRN-Costly External Equity: Implications for Asset Pricing Anomalies by Dongmei Li, Erica Li, Lu Zhang

In a paper that will definitely be mentioned in my corporate finance classes, Li, Li, and Zhang look at whether capital structure impacts pricing anomalies. They find they do. This at least is consistent with the idea that financial flexibility is important in choosing capital structure

SSRN-Costly External Equity: Implications for Asset Pricing Anomalies by Dongmei Li, Erica Li, Lu Zhang: From the abstract :

"...document that the value, net stock issues, investment, and asset growth anomalies tend to be stronger in financially more constrained firms than in less constrained firms. This effect of financial constraints is distinct from that of financial distress on anomalies. Intuitively, costly external finance makes marginal costs of investment more sensitive to investment in more constrained firms, giving rise to a stronger negative correlation between investment and the discount rate."

Two fast look-ins:

"Using bond ratings to measure costly external finance, we find that in the unconstrained sub-
sample consisting of firms whose bonds are rated, the value-weighted average return, CAPM
alpha, and Fama-French (1993) alpha for the high-minus-low investment-to-assets quintile are
−0.33%,−0.41%, and −0.14% per month. These estimates are either close to or more than halved in magnitude from their counterparts in the constrained subsample consisting of firms whose bonds are not rated. The differences across the unconstrained and constrained subsamples are all more than 2.8 standard errors from zero."

and also :

"[This] work adds to the literature that explores asset pricing implications of financial constraints. Lamont, Polk, and Sa´a-Requejo (2001) show that more constrained firms earn lower average returns than less constrained firms. Campello and Chen (2005) find that the bonds of more constrained firms earn higher ex ante risk premiums, which also covary with macroeconomic fluctuations. Building on Almeida and Campello (2007), Hahn and Lee (2005) study the effect of debt capacity on stock returns across constrained and unconstrained samples. Whited and Wu (2006) construct an index of financial constraints via structural estimation and find that more constrained firms earn insignificantly higher average returns than less constrained firms."

The take-away? It again seems that capital structure matters and that access to capital markets is an important consideration in both returns and in understanding anomalies.

Cite: Li, Dongmei, Li, Erica X. N. and Zhang, Lu,Costly External Equity: Implications for Asset Pricing Anomalies(September 8, 2008). Ross School of Business Paper No. 1111
Available at SSRN: http://ssrn.com/abstract=1154002