This paper uses research and development (R&D) data to examine the link between asset prices and financing constraints. Through a continuous-time real options model I show that there is a strong positive relation between financing constraints and stock returns, but only for high-R&D firms. Conversely, the model also predicts a strong positive relation between R&D and returns for highly constrained firms. Empirical results confirm these predictions. These findings not only explain the puzzling flat relation between financial constraints and stock returns documented in the literature, but also shed light on the economic source of the predictability of R&D investment on stock returns.
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