Is the cost of equity a mere function of leverage? The case of bond IPOs

Jamal A. Al‐Khasawneh, Paul Dion, Naceur Essaddam and Tashfeen Hussain

International Journal of Finance & Economics, 2023, vol. 28, issue 1, 58-78

Abstract: In this paper, we investigate how undertaking a bond IPO influences a firm's cost of equity. Using a sample of nearly 600 firms that have gone through a bond IPO over the 1980–2014 period, we show that the change in the cost of equity that results is not just a function of leverage influencing the risk of residual owners. The information and monitoring environment, and agency relationships of a firm change significantly with its first public debt, and these changes can have a significant impact on the firm's cost of equity. We find that firms that have relatively high information asymmetry before they undertake the bond IPO experience less of a rise in their cost of equity than firms with relatively low information asymmetry consistent with these firms benefitting from improvements in their information environment as a result of the IPO. We also show that firms with high pre‐bond IPO free cash flow see less of an increase in their cost of equity than firms with low pre‐bond IPO free cash flow consistent with the disciplining mechanism of additional debt and the benefit from additional monitoring. In addition, we find that firms with poor corporate governance experience less of an increase in their cost of equity after the bond IPO than firms with better corporate governance. The evidence suggests that the change in the riskiness of equity after a firm goes through a bond IPO is much more complex than what is predicted by the leverage increase.

Date: 2023
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