Institutional Ownership, Cost of Capital, and Corporate Investment

Neoclassical models postulate that firms’ investment is determined by expected profitability and the cost of capital. Capital market imperfections, caused by information asymmetries and agency costs, lead to a modified investment scenario, where the external cost of capital is higher than the cost of internal funds. This, in turn, leads to the well-known result of underinvestment by firms. We hypothesize in this study that institutional investors alleviate some of the capital market frictions by their relatively efficient information processing and managerial monitoring activities, thereby mitigating the underinvestment problem. In support of this hypothesis, we provide evidence indicating that: (1) The size of institutional ownership in public companies is positively related to the rate of investment in fixed assets, corporate acquisitions, and R&D; (2) institutions that trade frequently attempting to exploit short-term mispricings are more effective in reducing information asymmetries and enhancing corporate investment than other institutions; and (3) institutional investors eliminate the documented mispricing of securities associated with business investments. Taken together, these findings suggest that institutional investors alleviate market imperfections, thereby mitigating the underinvestment problem.