Product market advertising and new equity issues

Abstract

We analyze the interaction between a firm's product market advertising and its corporate financing decisions. We consider a firm that faces asymmetric information in both the product and financial markets and that needs to raise external financing to fund its growth opportunity (new project). Any product market advertising undertaken by the firm is visible to the financial market as well. In equilibrium, the firm uses a combination of product market advertising, equity 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. The following two predictions arise from our theoretical analysis for the relation between product market advertising and equity underpricing around new equity issues. First, firms choose a higher level of product market advertising when they are planning to issue new equity, compared with situations in which they have no immediate plans to do so. Second, product market advertising and equity underpricing are substitutes for a firm issuing new equity. We empirically test the above two predictions and find supporting evidence in the context of firms making initial public offerings and seasoned equity offerings.