Should a firm have any interest in the market liquidity of its securities? This question is central in much of the research in market microstructure. Previous studies have tried to answer this question by relating liquidity to the firm's cost of capital. However, the empirical evidence to date on this issue is somewhat mixed. This paper takes a different approach to test whether liquidity matters to the firm by examining an event that links liquidity to an easily observable component of the firm's cash flows.
We hypothesize that when firms access the external equity capital markets, the liquidity of their stock has an influence on the transactions costs specifically, the investment banking fees—associated with floating new equity. Using a large sample of seasoned equity offerings (SEOs), we test this hypothesis and find that, ceteris paribus, investment banks' fees are substantially lower for firms with more liquid stock.
The rationale for why liquidity might affect the cash flows (i.e., the flotation costs) associated with a seasoned equity offering is that the costs faced by the investment banking group are similar in spirit to those of other market makers such as dealers, specialists, or block traders who line up buyers and sellers to facilitate the intermediation process. For example, the underwriting syndicate may face inventory risk from receiving the shares as well as adverse selection risk if they maintain a net position in the stock.
Further, the investment banking group may also incur sunk costs in seeking out investors and processing the transactions. As a result, the more liquid the market for the underlying stock, the easier it is for the investment bank to place the new issue and reduce these intermediation costs. Since it should be easier to place an equity issue in a liquid market than to place it in an illiquid market, the stock market liquidity of the issuing firm should be an important determinant of the investment banking fees.
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Does Stock Market Liquidity Matter? Evidence from Seasoned Equity Offerings
