Do Firms Choose Their Stock Liquidity?
A Study of Innovative Firms and Their
Stock Liquidity
Nishant Dass
Vikram Nanda
Steven C. Xiao
Motivation
 Stock liquidity is a desirable feature for some firms
 Higher liquidity is associated with lower expected return on
assets and thus lower cost of capital (Amihud and
Mendelson,1986)
 Liquid stock, which incorporates more information in the
price, plays a stronger role in monitoring the managers
(Holmström and Tirole, 1993)
 However, not every firm may want or need liquidity –
facilitates market for corporate control; leakage of
proprietary information..
Motivation
 Firms can adopt liquidity-enhancing policies to
improve liquidity
- Amihud and Mendelson (2000) suggest a number
of means to increase stock liquidity including
increasing investor base and reducing information
asymmetry.
- Many papers have linked changes in liquidity to
firm actions such as equity issuance
Motivation
 However, evidence documenting the efforts of
firms to improve the stock liquidity is lacking
 We ask whether firms choose stock liquidity
by studying a group of firms that, we contend,
are more reliant on equity financing:
innovative firms
Motivation
Firms with focus on innovation produce unique
products
– Firms with unique products will have greater ripple
effects of bankruptcy on their customers, suppliers,
and workers. (Titman, 1984; Titman, Wessels, 1988)
Innovative firms tend to have more intangible assets
which have lower collateral value
Therefore, innovative firms will have lower leverage
ratios and more reliant on equity financing
Motivation
 We classify firms as innovative either by their
investments in R&D or number of patents/citations
 Intuitively, one would expect innovative firms to
have lower stock liquidity as their assets are
informationally more opaque to the market
 However, we find that innovative firms are positively
associated with stock liquidity, suggesting that these
firms might be taking deliberate actions to improve
their stock liquidity.
Motivation: Summary of Findings
 We identify that innovative firms indeed take actions that are
known to improve liquidity:
- Issue more frequent guidance (Coller and Yohn, 1997)
- More likely to do stock splits (Muscarella and Vetsuypens, 1996;
Lin, Singh and Yu, 2009)
- More likely to make SEOs (Eckbo et al., 2000; and Kothare,
1997)
- More likely to hire reputed underwriter (Amihud and
Mendelson, 1988; Ellis, Michaely and O’Hara, 2000)
- More likely to have option listed (Mayhew and Mihov, 2004)

More importantly, these actions do help innovative firms
improve their stock liquidity
Motivation: Summary of Findings (cont)
 An exogenous increase in liquidity improves firm value
and such effect is stronger for innovative firms
- we find that this stronger effect is concentrated among
innovative firms with more equity-based compensation
 Innovative firms are more likely to have access to
public debt, higher credit rating, and fewer
(quantitative) covenants in bank loans
 The role of monitoring is taken by equity holders
- Innovative firms are associated with higher institutional
ownership, higher likelihood of a blockholder, and higher
equity-based compensation for managers
Hypotheses
 H1: Innovative firms have greater stock liquidity but
less so when they have access to alternative sources
of capital or less financially constrained
 H2: Innovative firms will take deliberate actions that
are known to improve stock liquidity
 H3: The impact of a marginal increase in liquidity on
value (Tobin’s Q) would be greater for innovative
firms
Data: Dependent Variables
 Four proxies for stock illiquidity
 Amihud’s (2002) Illiquidity:
 Negative Turnover:
Data: Dependent Variables
 Bid-Ask Spread:
 Probability of Informed Trading (PIN) by Easley, Kiefer,
O’Hara, and Paperman (1996)
Data: Innovativeness
 R&D: ratio of R&D expenditure to lagged assets
 Log Patent: log( 1 + number of patents/100)
 Log Citation: log( 1 + number of citations/100)
 Innovation Index: first principal component of the
correlation matrix for the three innovativeness measures.
Empirical Analysis: H1
 To confirm the negative association between
innovativeness and illiquidity, we estimate the
following model:
Firm characteristics includes: Log Assets, Leverage, Cash,
Tobin’s Q, NYSE Dummy, ROA, Tangibility, Firm’s Age,
Return Volatility
Empirical Analysis: H1
Empirical Analysis: H1
 H1: Innovative firms have greater stock liquidity but
less so when they have access to alternative sources
of capital
 Test whether relationship between innovativeness and
illiquidity is weaker when firms have access to public
debt, high market power, and pay dividend:
Empirical Analysis: H1
Empirical Analysis: H2
 H2: Innovative firms will take deliberate actions that
are known to improve stock liquidity
 We test whether innovative firms issue more frequent
earnings guidance, more likely to have stock splits,
more likely to make SEOs, and more likely to hire
reputed underwriter
Empirical Analysis: H2
Empirical Analysis: H2
 H2: Innovative firms will take deliberate actions that
are known to improve stock liquidity
 We test whether these actions indeed improve stock
liquidity
 We instrument actions with industry median (or
mean) of these action variables to rule out
endogenous decisions
Empirical Analysis: H2
Empirical Analysis: H3
 H3: The impact of a marginal increase in liquidity on
value (Tobin’s Q) would be greater for innovative
firms
 We test whether an exogenous change in illiquidity
negatively impact Tobin’s Q
 First, instrument change in illiquidity with median
change in illiquidity of the industry
Empirical Analysis: H3
Empirical Analysis: H3
 Second, we look at an exogenous shocks to the firms’
stock illiquidity -- decimalization
 Specifically, we test whether change in illiquidity
surrounding decimalization negatively impact firm
value
Empirical Analysis: H3
Empirical Analysis: Debt of Innovative Firms
 What type of debt financing do innovative firms
prefer?
 We argue that attempts of innovative firms at
mitigating the information asymmetry in stock
market benefit them in the debt markets
 Firm also lower the information asymmetry by
generating information in the public debt markets
 Due to lower leverage ratio, innovative firms should
receive favorably from creditors
Empirical Analysis: Debt of Innovative Firms
 We find that innovative firms:
- Are more likely to have public debt
- Higher credit rating
- Fewer (quantitative) loan covenants
Empirical Analysis: Who Monitors Innovative Firms?
 Innovative firms have lower leverage ratio and
fewer covenants in their bank loans
 Due to reliance on equity financing, equity
holders assume the role of monitoring
 We find that innovative firms have greater
institutional ownership, more likely to have
blockholders, and higher equity-based
compensation
Empirical Analysis: Who Monitors Innovative Firms?
Empirical Analysis: Does Incentive Contract Help?
 Innovative firms, whose assets and managers’ decisions
are more opaque, benefit more from incentive contract
 We examine whether value effect of liquidity is greater
for innovative firms with high equity-based
compensation
 We test this again with the exogenous shock to liquidity
(decimalization)
Empirical Analysis: Does Incentive Contract Help?
Concluding Remarks
 Innovative firms are positively associated with
stock liquidity
 Innovative firms take actions to improve
liquidity and these actions do work
 Innovative firms benefit more than others by
having higher stock liquidity in terms of firm
value
Concluding Remarks
 Innovative firms return to public capital
markets, which helps reduce information
asymmetry; their private debt is less likely to
have covenant or fewer covenants if any
 Equity-holders assume the role of monitoring
innovative firms
 As innovative firms have greater incentive
contract, an exogenous decrease in illiquidity
increases firms’ value more than other firms,
consistent with the argument of Holström and
Tirole