Equity Financing Risk

Abstract

We develop a model of equity financing risk (EFR; i.e., risky equity issuance costs) to study the joint effects of precautionary savings and research and development (R&D) investments on expected returns. Our evidence confirms the model: (1) financial slack (i.e., liquid assets relative to R&D) lowers EFR exposure and thereby expected returns, (2) equity issuance lowers expected returns by increasing financial slack, and (3) these effects are concentrated among unprofitable firms. Moreover, an EFR factor yields a premium of 1.45% per month (t = 4.80), subsumes the Fama-French (2015) and Hou-Xue-Zhang (2015) investment factors, and helps explain anomalies related to R&D and cash-based operating profitability.

Keywords: Equity returns, R&D, financing constraints, equity issuances, factor models

JEL Classification: G12, G31, G35