...investment decisions. This relation is robust to alternative measures of growth opportunities, and is consistent with a liquidity premium in equity returns. That is, an increase in liquidity effectively expands the set of positive NPV projects because it reduces the cost of capital. The results suggest that liquidity-enhancing events benefit shareholders by increasing the pool of viable growth opportunities.

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Finance theory suggests that liquidity is a priced factor in expected asset returns because investors demand compensation for expected trading difficulty. In this context, Amihud and Mendelson (1986, 1988) argue that increases in stock liquidity will be positively related to firm value, because assets in place are discounted at a lower cost of capital when stock liquidity improves. However, it is difficult to test this theory because expected returns are not directly observable. Several researchers address this problem by using realized returns as a proxy for expected returns and find evidence consistent with theoretical predictions. (1)

In this article, we investigate the liquidity premium hypothesis from a different perspective. Myers (1977) argues that firm value is comprised of both assets in place and valuable investment opportunities. If required equity returns, and thus the cost of capital, is lowered as a result of an increase in stock liquidity, one would expect, at the margin, an expansion in the investment opportunity set. We test whether investment opportunities are increasing in stock liquidity, and thus provide a relatively unexplored implication of the liquidity premium hypothesis.

We conduct our analysis on firms that are added to the Standard and Poor's 500 Index (S&P 500) between January 1980 and December 2000. This sample is well suited for testing the relation between stock liquidity and investment opportunities for two reasons. First, the evidence indicates that on average, firms added to the index experience a significant permanent increase in stock liquidity (see, for example, Hegde and McDermott, 2003; Chordia, 2002). Second, the post-listing increase in liquidity is an exogenous event, in the sense that firms do not self-select into the S&P 500. Rather, Standard and Poor's selects index candidates based on public information, including market capitalization, industry grouping, stock liquidity, and fundamental analysis. (2) Thus, our empirical tests are not likely to be biased by unobservable firm characteristics that determine an endogenous decision to enhance stock liquidity.

In the empirical analysis, we first confirm the liquidity improvement following index inclusion documented in other studies. We then test the hypothesis that an increase in stock liquidity expands the viable investment opportunity set. Using realized capital expenditures as a proxy for growth opportunities, we find significant abnormal increases in this variable following index addition. Consistent with our hypothesis, these changes in capital expenditures are positively related to changes in stock liquidity, and persist when we control for pre-addition investment opportunities, stock returns, capital expenditure momentum, and financial slack, as well as post-addition changes in the information environment and internally generated funds. We find similar relations between stock liquidity and growth opportunities when we use alternative, ex ante, measures of growth prospects, such as research and development spending, book-to-market, and analysts' long-term growth forecasts.

This article complements an emerging body of empirical literature that explicitly examines links between corporate finance and the market microstructure of a firm's stock. These studies include evidence that investment banking fees for seasoned equity offers are lower for firms with greater stock liquidity (Butler, Grullon, and Weston, 2005), that firms with lower stock liquidity are more likely to pay dividends (Banerjee, Gatchev, and Spindt, 2005), and that stock liquidity interacts with debt policy (Lipson and Mortal, 2004, and Lesmond, O'Connor, and Senbet, 2003). We contribute to this literature by providing insight into how frictions in a firm's trading environment can constrain its investment opportunities. Our evidence supports the recommendations of Amihud and Mendelson (1988) that corporate managers should be aware of and seek to improve stock liquidity as they pursue the objective of maximizing shareholder wealth.

The article is organized as follows. Section I describes the data and study design, Section II contains univariate evidence of changes in stock liquidity and capital expenditures, and Section III contains multivariate tests of changes in capital expenditures on changes in stock liquidity. Section IV reports results of additional tests, and Section V concludes.

I. Data

We draw our sample from firms added to the S&P 500 index because of existing evidence of an increase in stock liquidity associated with index addition. To identify abnormal changes in investment opportunities following index addition, we also collect data for a matched control sample.

A. Sample Selection and Descriptive Statistics

We begin the sample selection process by identifying non-financial firms that are added to the S&P 500 between January 1980 and December 2000, using data obtained from Standard & Poor's. The final sample comprises 185 firms that we are able to match with control firms using the procedure described later in this section. Table I, Panel A, reports the distribution of industries represented by nine or more sample firms. There are 32 total industries, with Business Services, Electronic Equipment, and Retail having the highest representation. Panel B reports the time series of index additions. It indicates active periods of index additions from 1984-1987 and 1998-2000, which reflect general trends in industry consolidation of non-financial firms.

It is possible that any changes we observe in investment opportunities following index addition reflect industry trends or result from pre-addition price momentum associated with firms added to the S&P 500. Thus, to identify abnormal changes in investment opportunities following addition, we create a control sample that we match to index firms by industry, size, prior returns, and book-to-market value of equity. We identify industry groups from Fama and French (1997), measure size by book value of assets, and measure book-to-market as the book value of equity, plus balance sheet deferred taxes, minus book value of preferred stock, scaled by market value of equity. Prior returns are buy-and-hold returns for the (-250, -30) day window before index addition.

We begin the matching procedure by using the population of firms on Compustat from 1980 to 2000 with the CRSP, Compustat, and IBES data available that we require for the analysis. Next, to ensure that firms are not candidates for matching in the years that they are in our sample of index additions, we delete observations for index firms in the year of, and three years before and after, their addition year. From this pool of potential matches, we identify the group of firms in the same Fama and French (1997) industry grouping with total assets and book-to-market within 40% of the sample firm, and delete firms that do not have potential matches after this screen. Finally, we select the firm with the closest prior stock return match, yielding 185 pairs of sample and control firms.

We note that the 40% matching band is wider than conventional 20% matching bands. As Hegde and McDermott (2003) show, S&P 500 firms are, on average, positive momentum stocks. This price run-up makes it difficult to find industry peers of similar size and prior returns. The industry match is necessary to ensure that any changes in investment opportunities we observe are firm-specific, and not due to overall changes in industry growth...

NOTE: All illustrations and photos have been removed from this article.




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