Earnings and Stock Market Reaction Because through these earnings, dividends are distributed; cash is reserved for

the future expenses, expenditures, and expansion, therefore earnings influence share prices (Easton, 1985; Francis & Schipper, 1999; Sadka, 2007). Sadka (2007) found variability in expected earnings was accounting for 70% variation in dividend-price ratio, showing earnings variability resulting in share price volatility. Hirshleifer, Hou & Teoh (2009) in line with Kothari, Lewellen, and Warner (2006), Sadka (2007) and Habib (2008) found the negative relationship between earnings surprises and stock prices & returns and reported that this relationship was deriving from the accrual component of earnings. Jayaraman (2008) found that earnings volatility was resulting in bigger bid-ask spread of shares than the cash flows volatility.

Good earnings bring waves of positive sentiments in external capital markets so increase in share price incurs (Chan, Jegadeesh & Lakonishok, 1996; Kinney, Burgstahler & Martin, 2002). Earlier papers of Ball and Brown (1968) and Beaver (1968) studied the impact of earnings announcement on stock returns and return volatility plus trading volumes respectively. Uncertain profitability increases the firms share price volatility (Pastor & Veronesi, 2003), and firms share price volatility is due to the decreasing return on equity (ROE) and volatility in ROE (Wei & Zhang, 2006). This return volatility is inversely related to future returns (Ang, Hodrick, Xing & Zhang, 2006). When firms earnings are volatile, investor starts neglecting any unexpected earnings announcement, resultantly equity market do not see any reaction (Collins & Kothari, 1989; Barth et al., 1999). Due to volatility, firms may find times with huge cash inflows and this create positive reaction in stock market and increase the prices. In this case managers may go for obtaining funds from external equity market and waste in non-optimal investment (Stein, 1996; Jensen, 2005; Gilchrist, Himmelberg & Huberman, 2005; Dong, Hirshleifer & Teoh, 2007; Polk & Sapienza, 2009). Dechow (1994) found that firms with changing working capital requirements, financing and investing decisions have more association of stock price to their earnings. Literature has found that earnings impact the stock price, when firms earnings become volatile, price of stock fell. When share price falls, it deprives the firms of option to generate big funds from the equity capital market. Therefore it can be mentioned here that volatile earnings disturb the relationship with the financing decision and capital investment.

Earnings volatility results in increased cost of capital and required rate of return. Researchers found a direct relationship between different cost of capital measures and earning volatility (Beaver, Kettler & Scholes, 1970; Minton & Schrand, 1999; Gebhardt, Lee & Swaminatham, 2001; Francis, LaFond & Olsson, 2004). Sometimes earnings volatility results in lower cash realization, increasing cost of external capital; therefore shortage of internal funds may restrict firms from going towards potential investments (Myers & Majluf, 1984; Stiglitz & Weiss, 1981). Sometimes huge cash inflow results in over-investment by the mangers for fulfilling vested interests (Jensen, 1986; Stulz, 1990; Morellec, 2004). Huge cash inflow also makes managers over-confident and they may invest beyond the optimal level (Roll, 1986; Heaton, 2002; Malmendier & Tate, 2005a & 2005b). One can say that cash flow volatility may result in underinvestment (Froot, Scharfstein & Stein, 1993) or overinvestment (Morellec & Smith, 2002). Higher external cost of capital make investments highly sensitive to cash flows volatility (Minton & Schrand, 1999). Therefore the role of earnings and earnings volatility cannot be denied, while deciding over the financing method. Because the earrings volatility impact the market value of stock, increase the interest rate for debt financing, makes internal source of funds uncertain, therefore the earnings volatility influence the investment decisions.

Theoretical Framework Despite the fact that ample literary attention has been directed towards the capital investment from centuries and for the capital structure for decades, literature has found that there is dearth of work on role of earnings and stock price volatility in determination of capital investments and the relationship between the capital structure and capital investments. Relationship between the capital structure and capital investments is well established (Aiavazian et al., 2005; Bernanke et al., 1993; Booth et al., 2001; Chan et al., 1995; Chen, 2004; DeAngelo et al., 2011; Dudley, 2012;Faulkender et al., 2012; Frank & Goyal, 2003; Friend & Ang, 1988; Graham & Harvey, 2001; Guariglia, 2008; Harris & Raviv, 1990; Helwege & Liang, 1996; Hovakimian, 2009; Huynh & Petrunia, 2010; Jensen, 1986; Lang et al., 1996; Marsh, 1982; Masulis, 1983; McConnell & Muscarella, 1985; Miller, 1991; Myers, 1977; Rajan & Zingales, 1995; Williamson, 1988); studies have focused on the role of internal capital markets and fund flows for the financing of the capital investments (Barth et al., 1999; Donaldson, 1961; Easton, 1985; Francis & Schipper, 1999; Koch, 1943; Kuh, 1963: Meyer & Glauber, 1964; Meyer & Kuh, 1957; Meyer & Strong, 1990; Myers and Majluf, 1984; Myers, 1984; Nazir &Afza, 2009; Sadka, 2007) but the role of uncertainty in those flows of funds was unintentionally neglected. Studies emphasized on the relationship between the stock price and returns with profitability and capital structure (Baker & Wurgler, 2002; Bekaert & Harvey, 1997, 2000; Bekaert, 1995; Bhandari, 1988; Bradley et al., 1984; Butler et al, 2005; Gilchrist et al., 2005; Harvey, 1995; Lev, 1974; Lipson & Mortal, 2009; Lucas & McDonald, 1990; Rajan & Zingales, 1995; Titman & Wessels, 1988; Welch, 2004; Yanga et al., 2010) but the role of stock price volatility on the relationship between the capital structure and capital investments was missed. A conceptual framework based on these deficiencies in the literature has been developed in order to fill this gap. This framework states that earnings volatility not only influences the capital investees but also the relationship between the capital structure and the capital investments. The stock price volatility also has the effects on the relationship between the capital structure and capital investments.

EARNINGS VOLATILITY

CAPITAL STRUCTURE

CAPITAL INVESTMENTS

STOCK PRICE VOLATILITY

Fig. 1. Conceptual Framework Summary of the Chapter The current discussed in detail the literature on the capital investments and its models, earnings volatility, capital structure and stock price volatility. In last section of the chapter conceptual framework has been presented for the current study. Next chapter is the mythology where this framework will be converted in equation forms and with help of hypotheses it will be empirically tested.

Minton, Schrand and Walther (2002) claimed that using models with volatility incorporated provide accurate and less biased results and forecasts under the underinvestment scenario.