Value Relevance, Idiosyncratic Risk, and External Financing Activities

Abstract

This paper first examines the effects of value relevance of earnings and incremental value relevance of cash flows on net external financing, net equity financing and net debt financing. The investors, in general, suffer beta risk and idiosyncratic risk of a firm. The former is the main determinant of risk premium, and the latter can be controlled by the manager. If the firm has better control of idiosyncratic risk, it implies the manager has larger influence on stock returns. Under control accruals, value relevance of earnings and incremental value relevance of cash flows, we also examine the effects of net external, net debt and net equity financings on idiosyncratic risk. To test whether the external financing policy of a firm is consistent with over-investment hypothesis, this study investigate the effects of net external, net debt and net equity financings on future stock returns under controlling for value relevance of earnings and cash flows. This paper further analyzes the relation between current idiosyncratic risk and future stock returns following financing activities. We find that external financing activities are positively related to value relevance of earnings but are unrelated to incremental value relevance of operating cash flows, and external financing is unrelated to value relevance of operating cash flows but is positively related to incremental value relevance of earnings. Moreover, debt financing is unrelated to value relevance of cash flows but is positively correlated to incremental value relevance of earnings, and equity financing is unrelated to value or incremental value relevance of earnings but is positively correlated to value relevance and incremental value relevance of cash flows. We also find that both value relevance of earnings and cash flows are positively correlated to idiosyncratic risk, and current idiosyncratic risk and equity financing are negatively correlated to future returns after controlling value relevance of earnings and cash flows.