Connecting Optimal Capital Investment and Equity Returns

Authors


  • I thank Lemma Senbet (the Editor) and the anonymous referee for their comments and suggestions. I also thank Michael Brandt, John Cochrane, Randy Cohen, George Constantinides, Mark Flannery, Anil Kashyap, Owen Lamont, and participants at the FMA meeting in New Orleans for helpful discussions.

Abstract

Economic theory predicts a contemporaneous correlation between equity returns and investment growth that is only weakly present in the data. By modifying the firm's production function to include a lag between investment decisions and expenditures, and after correcting for the temporal aggregation of investment, I find the predicted correlation to be present in the data. I estimate the model for 31 industries and find that investment returns are highly correlated with the industry portfolio equity returns. Further, the portion of investment returns orthogonal to equity returns is associated positively with changes in profitability and negatively with lagged differences between equity and investment returns.

Ancillary