Using Firm-Level Favoritism to Better Understand the External Financing and Capital Expenditure Anomalies

Abstract

Prior literature documents a positive (negative) relation between past (future) stock returns and both external financing and capital expenditures. There has been much debate in the literature regarding the mechanisms driving these relations. In this study, we employ both a stock’s extreme return momentum and extreme trading volume to capture firm-level overpricing (underpricing) due to investor favoritism (neglect). We find that favoritism (neglect) is positively (negatively) associated with external financing decisions, and that the previously documented negative association between external financing and future stock returns is more pronounced in periods of favoritism. In contrast, after controlling for external financing, the positive (negative) association between favoritism (neglect) and capital expenditure decisions is attenuated, and we do not find the previously documented negative relation between capital expenditures and future stock returns. These findings suggest that financing decisions, but not capital expenditure decisions, are associated with managers’ exploitation of investor mispricing.