Working Paper: NBER ID: w21064
Authors: Gian Luca Clementi; Berardino Palazzo
Abstract: We confront the one-factor production-based asset pricing model with the evidence on firm-level investment, to uncover that it produces implications for the dynamics of capital that are seriously at odds with the evidence. The data shows that, upon being hit by adverse profitability shocks, large public firms have ample latitude to divest their least productive assets and downsize. In turn, this reduces the risk faced by their shareholders and the returns that they are likely to demand. It follows that when the frictions to capital adjustment are shaped to respect the evidence on investment, the model–generated cross–sectional dispersion of returns is only a small fraction of what documented in the data. Our conclusions hold true even when either operating or labor leverage are modeled in ways that were shown to be promising in the extant literature.
Keywords: Investment; Asset Pricing; Equity Returns
JEL Codes: D24; D92; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Adverse profitability shocks (E32) | Divestment of least productive assets (G33) |
| Divestment of least productive assets (G33) | Reduced risk faced by shareholders (G32) |
| Reduced risk faced by shareholders (G32) | Lower returns demanded by shareholders (G19) |
| Adverse profitability shocks (E32) | Lower expected returns (G19) |