Working Paper: CEPR ID: DP4829
Authors: Massimo Massa; Urs Peyer; Zhenxu Tong
Abstract: We focus on an exogenous event that changes the cost of capital of a company ? the addition of its stock to the S&P 500 index ? and investigate how companies react to it by modifying their corporate financial and investment policies. This allows us to test capital structure theories in an ideal controlled experiment, where the effect of the index addition on the stock price is exogenous from a manager?s point of view. Consistent with both traditional theories and Stein?s (1996) market timing theory, we find more equity issues and increases in investment in response to higher index addition announcement returns. However, in the 24 months after the index addition, firms that issue equity and increase investment display negative abnormal returns and they perform worse than firms that issue but do not increase investment. This finding is consistent only with the market timing theory of Stein (1996) and supports a ?limits of arbitrage? story in which the stocks display a downward sloping demand curve and companies themselves act as ?arbitrageurs? taking advantage of the window of opportunity.
Keywords: corporate financial policies; limits of arbitrage; market timing
JEL Codes: G30; G31; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| addition of a company's stock to the S&P 500 index (G34) | increase in its stock price (G19) |
| increase in its stock price (G19) | more likely to issue equity (G24) |
| increase in its stock price (G19) | increase investment (E22) |
| higher abnormal return (G17) | more likely to issue equity (G24) |
| higher abnormal return (G17) | increase investment (E22) |
| firms that issue equity and increase investment (G24) | negative long-run abnormal returns (G14) |
| constrained firms that issue equity and increase investment (D25) | underperform in the long run (D29) |
| unconstrained firms that issue equity and increase investment (D25) | negative long-run returns (G19) |