Product Market Advertising and Initial Public Offerings: Theory and Empirical Evidence

49 Pages Posted: 25 Jan 2004

See all articles by Thomas J. Chemmanur

Thomas J. Chemmanur

Boston College - Carroll School of Management

An Yan

Fordham University - Gabelli School of Business

Date Written: March 15, 2004

Abstract

Practitioners have noted that firms tend to increase their product market advertising prior to an IPO or a seasoned equity issue. Further, recent empirical evidence indicates that firms with a greater level of product market advertising have lower bid-ask spreads and a larger number of both individual and institutional investors in their equity. We develop a theoretical model of the interaction between a firm's product market advertising and its corporate financing decisions in the above context. We consider a firm which faces asymmetric information in both the product and the financial market (about the quality of its products and the intrinsic value of its projects) and which needs to raise external financing to fund its growth opportunity (new project). Any product market advertising undertaken by the firm is visible in the financial market as well. We show that, in equilibrium, the firm uses a combination of product market advertising, IPO underpricing, and underfinancing (raising a smaller amount of external capital than the full information optimum) to convey its true product quality and the intrinsic value of its projects to consumers and investors. Our model has several implications for IPO underpricing and product market advertising. Two of these predictions are as follows. First, firms will choose a higher level of product market advertising when they are planning to issue new equity or other information-sensitive securities, compared to situations where they have no immediate plans to sell such securities. Second, product market advertising and IPO underpricing are substitutes for a firm going public. The empirical evidence supports these two predictions: First, firms indeed increase their product market advertising in their IPO year relative to a benchmark year two years before their IPO. Further, we find that, in the five-year span around the IPO year (i.e., the IPO year, and the two years before and after the IPO year), the peak advertising level is reached in the IPO year. Second, the extent of underpricing is smaller as the level of product market advertising is greater.

Keywords: Initial public offerings, advertising

JEL Classification: G3

Suggested Citation

Chemmanur, Thomas J. and Yan, An, Product Market Advertising and Initial Public Offerings: Theory and Empirical Evidence (March 15, 2004). EFA 2004 Maastricht Meetings Paper No. 3121, Available at SSRN: https://ssrn.com/abstract=486713 or http://dx.doi.org/10.2139/ssrn.486713

Thomas J. Chemmanur

Boston College - Carroll School of Management ( email )

Finance Department, 436 Fulton Hall
Carroll School of Management, Boston College
Chestnut Hill, MA 02467-3808
United States
617-552-3980 (Phone)
617-552-0431 (Fax)

HOME PAGE: http://https://www2.bc.edu/thomas-chemmanur/

An Yan (Contact Author)

Fordham University - Gabelli School of Business ( email )

113 West 60th Street
New York, NY 10023
United States
212-636-7401 (Phone)
212-765-5573 (Fax)

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