Do initial public offerings reduce the cost of debt? Evidence from China

Purpose The purpose of this study is to examine whether initial public offerings (IPOs) can reduce the cost of debt for small and medium-sized enterprises (SMEs). Design/methodology/approach This study uses a sample of 5,770 firm-year observations, with 44.51% (55.49%) of them obtained from listed (unlisted) firms in China, for regression analyses. In addition, the authors construct an instrumental variable (IV) based on the change in the IPO approval rate over time, which is largely affected by political factors and considered exogenous to corporate management, to demonstrate the causal effect of IPOs on the cost of debt. Findings The results of baseline regressions suggest that IPOs reduce the cost of debt by 16.2162%. Additional analyses show that IPOs have positive effects on the number of corporate employees, R&D expenses and the ratio of employees with bachelor’s or postgraduate degrees, which is consistent with the notion that IPOs alleviate firms’ financial constraints by reducing the cost of debt. Originality/value This study makes three important contributions. First, the authors use a sample containing unlisted firms and conduct IV analyses to address potential selection bias and endogeneity issues and by doing so, demonstrate the negative effect of IPOs on the cost of debt. Second, the authors lend support to agency theory in explaining the cost of debt. Third, the authors highlight that the reduced cost of debt after the IPO provides a new perspective in explaining why firms are willing to accept puzzlingly high IPO underpricing.