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130024 DEBT EQUITY FINANCING CHOICE UNDER FINANCIAL CONSTRAINTS: DOES CORPORATE SOCIAL RESPONSIBILITY MATTER?

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DEBT EQUITY FINANCING CHOICE UNDER FINANCIAL CONSTRAINTS: DOES

CORPORATE SOCIAL RESPONSIBILITY MATTER?

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DEBT EQUITY FINANCING CHOICE UNDER FINANCIAL CONSTRAINTS:

DOES CORPORATE SOCIAL RESPONSIBILITY MATTER?

ABSTRACT

This study examines the role of corporate social responsibility (CSR) activities in a firm’s

debt and equity financing decisions and in the level of underpricing of secondary equity offerings

(SEO). We find that high CSR firms tend to use more debt financing and less equity financing than

low CSR firms. We also find that firms tend to follow the pecking order’s financing hierarchy

when they are financially constrained. Finally, we find that the high CSR firms that raise equity

capital experience a significantly lower level of SEO underpricing than low CSR firms.

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DEBT EQUITY FINANCING CHOICE UNDER FINANCIAL CONSTRAINTS:

DOES CORPORATE SOCIAL RESPONSIBILITY MATTER?

I. INTRODUCTION

A vast literature in both management and finance on corporate social responsibility

unanimously supports that CSR can have a positive impact on firm performance because firms can

better access to valuable resources as well as lager customer base. CSR also promotes a firm’s

reputation and branding equity, hence allowing for better marketing of products and services. CSR

help firms attract and retain higher quality employees. In the meta-study of 52 CSR and firm

performance by Orlitzky, Schmidt, & Rynes (2003), none investigates the association between

CSR and the pricing of equity offerings. Only recently, a few studies focus on the link between

the CSR and the cost of equity which examine the impact of firms’ CSR behavior on their implied

cost of capital based on the investors’ perceived risk of the firms. Dhaliwal, Li, Tsang, & Yang (

2011) investigate the impact of standalone voluntary disclosure of CSR issues on the cost of equity

and find that firms exploit the benefit of lower cost of capital by initiating the disclosures of their

CSR activities. They also find that firms are more likely time their equity offerings following their

initiations of CSR disclosures.

Using several approaches to estimate firms’ implied cost of equity based on perceived risk

of investors, El Ghoul, Guedhami, Kwok, & Mishra (2011) provide evidence that firms with better

CSR score are more likely experience lower discount rate, hence cheaper cost of equity. In

addition, they find that firms in “sin” industries such as fire arm, tobacco, nuclear power face

higher the implied cost of equity due to higher perceived risk. Goss & Roberts (2011), examining

the link between CSR and bank debt, find that firms with social responsibility concerns pay higher

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interest rate than firms that are more responsible. Using 3996 loans to US firms, they provide

evidence that firms with lower CSR score face higher loan spreads and shorter maturities.

Our study is related to, but differs from the work of El Ghoul et al., (2011) and Goss &

Roberts (2011). El Ghoul et al., (2011) mainly focus on the effects of CSR on the implied cost of

equity regarding the investors’ perceived risk of firms engaging social responsibility activities.

Although prior studies generally show the effects of CSR on the cost of equity and debt in terms

of higher implied cost of equity and higher interest rates, they do not quantify the effects of CSR

on the pricing of seasoned equity offerings. We contribute to the current literature by examining

the direct impact of CSR on firm’s debt-equity choice in financing decisions and firm value. More

specifically, we examine whether firms with high CSR scores can follow the pecking order in

raising external capital. In addition, we also examine the effects of CSR on the SEO underpricing

based on a decrease or increase of the perceived risks. Once a firm’s higher CSR is observed,

investor may react favorably to the firms’ new equity offerings. This suggest that the likelihood of

firm to issue new equity is positively associated with the CSR activities. Our main hypothesis is

that a higher level of corporate social responsibility is associated with the pecking order’s

hierarchy financing decisions for financially unconstrained firms and lower level of the

underpricing of seasoned equity offerings.

To our current knowledge, this is the first study that directly connects CSR with the pecking

order of financing decisions and SEO underpricing. The remainder of this paper is organized as

follows. Section 2, which follows this introductory section, provides related literature and

hypothesis development. Section 3 describes the sample construction and data sources, Section 4

provides descriptive statistics and empirical results. Finally, Section 5 concludes the paper.

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II. RELATED RESEARCH AND HYPOTHESIS DEVELOPMENT

The terms “corporate social responsibility” and “corporate social performance” have

become increasingly popular in the economics, finance and accounting literature over the past two

decades, (Cochran & Wood, 1984; El Ghoul et al., 2011 ; Wu & Shen, 2013; and Lins, Servaes, &

Tamayo, 2017)). Prior research suggests that corporate social responsibility (CSR) is value-

enhancing for shareholders by reducing agency costs due to enhancing stakeholder engagement,

and by lowering informational asymmetry due to higher transparency. Investing in CSR is

considered as an enabler of collective action and cooperation, leading to lower transaction costs

and more efficient allocation of resources (Lins et al., 2017).

Cochran & Wood, (1984) argue that CSR investments provide firms with better access to

valuable resources. Cheng, Ioannou, & Serafeim, (2014) show that high-CSR firms are more able

to access finance in capital markets. (Lins et al., 2017) find that firms build social capital and

stakeholder trust through CSR investments. The investments in CSR pay off because being

trustworthy are more valued, especially in unexpected low trust periods such as financial crises.

The extant literature provides evidence suggesting that high CSR firms are rewarded in both debt

and equity markets.

In debt markets, credit rating agencies tend to award higher debt ratings (Attig, El Ghoul,

Guedhami, & Suh, 2013; El Ghoul et al., 2011) and banks tend to offer lower loan interests (Goss

& Roberts, 2011) to high CSR firms. Shi and Sun (2015) show that CSR investments help to reduce

the number of bond covenants because better CSR performance can earn a firm good reputation

and increased transparency. Oikonomou, Brooks, & Pavelin (2014) investigate the impact of CSR

performance on the pricing of bond pricing and find that high CSR firms are rewarded in bond

markets through lower bond yields spreads.

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In equity markets, high CSR firms tend to have a lower implied cost of equity capital than

low CSR firms (El Ghoul et al., 2011). Examining the motives of the first-time CSR reporting

firms, Dhaliwal et al., (2011) argue and find that firms plan to voluntarily disclose their first CSR

reports to reduce the cost of equity capital before raising equity capital. Their findings indicate that

firms with a high cost of equity capital in the previous year tend to initiate their first CSR

disclosure, and that initiating firms with higher CSR performance experience a subsequent

reduction in the cost of equity capital.

It is worth to note that (Dhaliwal et al., 2011) only focus on the sample of firms that

initiating their first CSR disclosures. Little do we know about the role of CSR in equity market

after their first years of CSR disclosure. This gap naturally raises questions among researchers:

What is the role of CSR in a firm’s equity financing decision in the subsequent years?

In this study, we aim to examine the role of CSR in debt-equity choices of firms and the

impact of CSR on SEO underpricing when firms go raise capital in equity markets. Our study is

related to, but different from and complement to the work of Dhaliwal et al., (2011). First, while

Dhaliwal et al. (2011) focus on the first year of CSR disclosure, we examine the role of CSR in

both first years and subsequent years. Dhaliwal et al., (2011) examine the impact of the initiations

of the first CSR report on the implied cost of equity capital and the likelihood of issuing equity in

subsequent year. We examine the impact of CSR on actual market valuations of SEOs by

measuring SEOs underpricing.

Our first hypothesis predicts that high CSR firms are less likely to issue equity than low

CSR firms. The argument is based on the pecking order theory and the findings in prior research.

As discussed earlier, high CSR firms are rewarded in both debt and equity markets through lower

costs of debt and lower implied costs of equity. The pecking order theory (S. C. Myers & Majluf,

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1984) explains that due to adverse selection, firms prefer internal to external finance. When

external finance is necessary, firms prefer debt to equity because of lower information cost

associated with debt and equity. Compared to debt issuance, equity is more rarely issued (Frank &

Goyal, 2003). Since high CSR firms are rewarded in both debt and equity market, the alternative

and available options in debt markets would encourage high CSR firms to use debt financing but

to eschew equity financing. Our first hypothesis, stated in an alternative form, as follows:

H1A: High CSR firms are more likely to issue debt and less likely to issue equity than

low CSR firms.

If we find evidence supports our first hypothesis, then why would some high CSR firms

still need to issue equity? The pecking order theory predicts that firms need to issue equity when

their ability to use internal funds or debt financing is limited. Continuing in this line of argument,

we argue that one of the reasons for high CSR firms to issue equity is their financial constraint.

Financial constraints induce higher financing costs and thus, restricting financing options because

financial constrained firms are viewed as low quality borrowers. Goss & Roberts (2011) find that

in the context of the absence of security, low quality borrowers that engage more in CSR activities

face higher loan spreads and shorter maturities, but lenders are indifferent to the level of CSR

activities of high quality borrowers. We propose that when facing financial constraints, firms tend

to turn from debt financing to equity financing. We therefore propose the next hypothesis, H1B,

stated as bellow:

H1B: Financial constraint mitigates the impact of CSR on debt issuance and the

impact of CSR on equity issuance.

As discussed earlier, prior studies high CSR firms are rewarded through lower costs of debt

and implied costs of equity(Attig et al., 2013; El Ghoul et al., 2011; Oikonomou et al., 2014). If

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CSR investments are viewed as value-enhancing for shareholders by reducing agency costs, and

by lowering informational asymmetry, then higher CSR firms should receive lower SEO

underpricing. This logic suggests our H2 hypothesis:

H2: The SEOs of high CSR firms are underpriced significantly less and the SEOs of

low CSR firms.

III. DATA SAMPLE

Data for this study come from several sources. The seasoned equity offerings data comes

from the Thomson Financial SDC database. The social performance rating scores are retrieved

from the MSCI ESG KLD Statistics.1 The MSCI ESG KLD provides corporate social

responsibility (CSR) performance for about 650 companies that comprise the FTSE KLD 400

Social Index and S&P 500® with one record for each company the in early 1990s. MSCI ESG

KLD expanded its coverage universe to include the largest 1,000 U.S. companies by market

capitalization in 2001 and during 2003-2013 the MSCI ESG KLD extended its coverage to the

largest 3,000 U.S. companies by market capitalization. The MSCI ESG KLD provides social

performance rating scores based on proprietary research profiles of corporate environmental,

social, and governance (ESG) factors. The MSCI ESG KLD data covers approximately 80

indicators in seven major issue areas: community; corporate governance; diversity; employee

relations; environment; human rights; and product quality and safety. Each issue area has a number

of strength and concern items, where a binary measure indicates the presence or absence of that

particular strength or concern. We follow prior studies (Chatterji, Levine, & Toffel, 2009; Johnson

& Greening, 1999; Kim, Park, & Wier, 2012; Waddock & Graves, 1997) to construct a CSR score

1 Formerly KLD data were created by KLD Research and Analytics Inc., MSCI acquired KLD in 2010.

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based on five social rating categories which include community, diversity, employee relations,

environment, and product. We use the annual scores to construct a composite CSR score for every

year and each firm. Particularly, our CSR1 score is measured as total strength minus total concern

in MSCI ESG KLD’s above five rating categories. For our robustness analysis, we construct a

second measure (CSR2) in a similar vein but excluding corporate governance to disentangle the

effect of CSR and corporate governance. The CSR1 and CSR2 are equally weighted average of

five (four) above rating categories for the focal firm for every year in our panel dataset.

The share prices needed to calculate SEO underpricing and the financial characteristics for

regression analysis are from the Center for Research in Security Prices (CRSP) and Compustat

North America. As in our empirical analysis, the focus is on the effects of corporate social

responsibility performance on a firm’s debt-equity choices and the underpricing of seasoned equity

offerings (SEOs), we start with the sample of all U.S. common equity offerings which can be

matched the MSCI ESG KLD database to obtain CSR rating scores. Because the MSCI ESG KLD

began providing CUSIP in 1995 and covering firms from 1991-2013, we match the MSCI ESG

KLD’s CSR scores with 2,761 SEOs of 1,402 non-regulated firms during the period 1995-2015.

We can extend our analysis for SEOs until 2015 because we examine SEOs up to two years

following the ending of MSCI ESG KLD data. In our subsequent regression analyses of debt-

equity choices, after matching MSCI ESG KLD rating scores with the financial data from the

Compustat database, we obtain a sample of 1,866 firms with 20,894 firm-year observations during

the period 1995-2015. We exclude observations from regulated firms in our sample.

IV. EMPIRICAL RESULTS

Descriptive Statistics

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Table 1 presents the number of observations, mean, the first quartile, median, the third

quartile and standard deviation of each of variables in the sample. The mean and median for SEO

underpricing is 3.7 percent and 2.6 percent respectively. The average CSR1 (CSR2) score in the

sample is 0.067 (-0.136), and firms seem to perform slightly better on community, diversity,

employee relations, environment, human rights, and product quality and safety than on corporate

governance dimension.

[Insert Table 1 about here]

Table 2 shows the Pearson correlation matrix of a set of selected variables of interest.

Consistent with our expectation stated in the first hypothesis, high CSR firms tend to issue more

debt and less equity than low CSR firms. The correlation coefficient between CSR1 and

DEBT_ISSUED is positively significant (0.103, p-value <0.01). The correlation coefficient of

CSR1 and EQUITY_ISSUED is negatively significant (-0.362, p-value <0.01). The correlation

coefficient between CSR2 and DEBT_ISSUED and between CSR2 and EQUITY_ISSUED shows

consistent results.

[Insert Table 2 about here]

As shown in Columns 1 and 2 of Table 2, both CSR scores (CSR1 and CSR2) are

significantly and negatively correlated with SEOUNDERPRICE, KZINDEX and SAINDEX. This

preliminary univariate results suggest that high CSR firms tend to have lower SEO underpricing

(supporting our hypothesis H2) and are less financially constrained than low CSR firms. As shown

in the last two rows of Table 2, KZINDEX and SAINDEX are negatively significantly correlated

with DEBT_ISSUED and positively significantly correlated with EQUITY_ISSUED. The results

indicate that firms with high financial constraints tend to issue more equity and less debt than firms

with low financial constraints.

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The Effect of CSR on Debt Equity Choices and the Likelihood of Equity Issuance

In this section, we present initial evidence on the effect of corporate social performance on

debt/equity issuance decisions. To test H1A hypothesis, we examine whether a high rating of

social corporate performance in the previous year gives firms to follow the pecking order of capital

structure in meeting their financing needs. According to Myers (1984), due to adverse selection,

firms prefer internal to external finance. When outside funds are necessary, firms prefer debt to

equity because of lower information costs associated with debt issue. In the words of Myers (1984,

p. 585): ‘‘you will refuse to buy equity unless the firm has already exhausted its ‘‘debt capacity”—

that is, unless the firm has issued so much debt already that it would face substantial additional

costs in issuing more.”

In the empirical regression model (see Equation 1 below), our dependent variable is the net

debt (net equity) issued, (DEBT_ISSUED in Columns 1 and 2 and EQUITY_ISSUED in Columns

3 and 4), in the year following the year in which firms engage CSR activities.

Equation 1:

Net(Debt / Equity)Issuei,t +1 = 0 + 1CSRi,t + 2 MTBi,t + 5 DEFICITi,t + 4 LEVERAGEi,t

+ 5 ADJRETURNi,t + 6 PROFITi,t + 7CAPEX i,t + 8SIZEi,t + 9 NOISEt + i,t

We follow Bradshaw et al. (2006) to construct net debt and net equity issuance variables. Net debt

issue (DEBT_ISSUED) is the change in total long-term debt during the year. The net debt issue

represents net cash received from the issuance (and/or reduction) of debt. Net equity issue

(EQUITY_ISSUED) is the net amount of cash from issuing and repurchasing equities during the

year. Net equity issue represents net cash received from the sale (and/or purchase) of common

and preferred stock less cash dividend paid. To avoid missing too many observations, we set

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current debt to 0 if it is missing in the Compustat database. In addition to CSR scores, we include

a number of control variables in the regression. The control variables include the 24-month

cumulative market adjusted returns (ADJRETURN), market to book ratio (MTB), market leverage

(LEVERAGE), financing deficit (DEFICIT), profitability (PROFIT), firm size (SIZE), market

liquidity condition (NOISE), and capital expenditures (CAPEX).

We control FIRMSIZE in our regression because prior studies (e.g. Kurshev and Strebulaev, 2015)

provide evidence that firm size has been empirically found to be strongly and positively correlated

with capital structure. Firm size has also been consistently found that large firms in the U.S. tend

to have higher leverage ratios than small firms. We control for growth opportunities (measured as

market to book ratio, MTB) because firms are more likely to issue equity when their market values

are high, relative to book and past market values, and to repurchase equity when their market value

are low (Baker & Wurgler, 2002). We include profit (PROFIT) in the model because profitable

firms have lower amount of debt since they have more available cash which can be used as internal

sources of fund to meet firms’ financing needs. We also control for capital expenditure expenses

(CAPEX) and financing deficit (DEFICIT) because higher level of CAPEX and DEFICIT would

induce firms to issue more debt or equity to meet their financing needs. If firms maintain a target

debt ratio, the firm are expected to weight the benefit from tax relief against the increase

bankruptcy risk that comes with leverage. In that case, firms over time would gradually adjust their

capital structure toward their optimal leverage targets. So, we control debt ratio (LEVERAGE) in

our model. Finally, we include market noise (NOISE), to control overall market liquidity condition.

We use the (Hu, Pan, & Wang's, 2013) NOISE variable which captures episodes of liquidity crisis

of different origins across financial market. Our Appendix provides detailed information about

variable definitions.

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Table 3 provides regression results of the effect of CSR on the choices of debt and equity

issuance. Our main dependent variable is net debt issuance (DEBT_ISSUED in Columns 1 and 2)

and net equity issuance (EQUITY_ISSUED in Columns 3 and 4). As shown in Columns 1 and 2

of Table 3, we find a significantly positive coefficient of CSR1 (0.570, p-value < 0.01, Column 1)

and of CSR2 (0.494, p-value < 0.01, Column 2). This coefficient indicates that firms with higher

CSR scores in year t is positively related to higher debt issue in the following year (year t+1). In

contrast, the coefficients on CSR score in model 3 and 4 (Columns 3 and 4 of Table 3) when net

equity issuance is the dependent variable are significantly negative. The coefficient of CSR1 is

negative 0.203 (p-value <0.01) and the coefficient of CSR2 is negative 0.236 (p-value <0.01) in

Columns 3 and 4 of Table 3, respectively.

The results suggest that there is a negative association between high CSR ratings in year t

and the net equity issue in the following year (year t+1). This suggests that firms with high CSR

ratings are more likely to follow the pecking order of capital structure in their financing decisions.

The results provide evidence supporting our first hypothesis, H1A.

While the coefficients of MTB in specification 1 and 2 are positive and not significant, the

coefficient on MTB is negative and statistically significant in specification 3 and 4. This is

consistent with prior studies that firms are more likely to issue equity when their stock prices are

high relative to the book value (growth firms).

[Insert Table 3 about here]

In sum, Table 3 reveals that, holding other factors constant, firms with high CSR ratings

are more likely to issue debt and less likely to issue equity in their financing decisions. The findings

support our first hypothesis (H1A) that high CSR firms actively engaging CSR activities before

going to the capital markets in anticipation of obtaining cheaper external capital financing by

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following the pecking order theory of capital structure. In other words, high CSR ratings possibly

allow firms to obtain cheaper external capital by tapping debt markets first before turning to equity

markets.

CSR and the Likelihood of SEOs under Financial Constraints

As discussed previously, we predict that firms with high CSR performance are more likely

to issue debt and less likely to issue equity in financing decisions compared with those with low

CSR performance. In this section, we test our H1B by examining whether CSR performance can

mitigate financial constraints in making financing choices. We hypothesize that the effect of CSR

performance on debt equity choices is more pronounced in financially unconstrained firms and not

observed in financially constrained firms. Financially unconstrained firms may actively engage in

corporate social activities, as predicted by the pecking order of financing decisions. However,

corporate social activities only have a second order effect on the debt-equity choice in financing

decisions and the benefits of following the pecking order’s financing hierarchy manifest only

among financially unconstrained firms. We estimate the following logistic regression for equation

2 and OLS regression for equation 3 to empirically test our hypothesis.

Equation 2:

log L prob(SEOi,t +T ) / (1- prob(SEOi,t +T ))lJ = 0 + 1CSRi,t + 2 SIZEi,t + 3MTBi,t

+ 4 MKTLEVi,t + 5 DEFICITi,t + 6 ADJRETURNi,t + 7 PROFITi,t + 8CAPEX i,t (2)

+ 9 NOISEt + IndustryIndicators + i,t

Equation 3:

Net(Debt / Equity)Issuei.t+1 = 0 + 1CSRi,t + 2 FINCONSTRi,t + 3CSRi,t X FINCONSTRi,t

+ 4 MTBi,t + 5DEFICITi,t + 6 LEVERAGEi,t + 7 ADJRETURNi,t + 8 PROFITi,t

+ 9CAPEX i,t + 10SIZEi,t + 11NOISEt + i ,t

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Where t=1 and t=2 denotes one year or two years following the disclosure of CSR rating scores.

Following prior studies, we use the KZ index and the SA Index as measures of financial constraints

(see Appendix for full details of variable definitions) and subsequently classify firms into

financially constrained or unconstrained subsamples. A firm with high KZ-index or SA index is

financially more constrained. Specifically, we rank firms based on the KZ-index (SA index) in

ascending order each year. The firms ranked in the top 30% percentile are placed in the financially

constrained subsample and firms in the bottom 30% percentile are placed in the financially

unconstrained subsample.

The SEO is a dummy variable that equals one if a firm issue equity over the next two years

following the disclosure of CSR rating scores. Net debt issue (DEBT_ISSUED), and net equity

issue (EQUITY_ISSUED) are measured by the total dollar amount in millions U.S. dollars issued

annually 1 year following the disclosure of CSR rating scores. The variable of interest is corporate

social responsibility (CSR). We also include independent variables controlling for other potential

factors affecting the debt or equity issuance. Other control variables include the 24-month moving

cumulative market adjusted returns (ADJRETURN) ending in June 30 each year, market-to-book

(MTB), market leverage (LEVERAGE), financing deficit (DEFICIT), profitability, firm size

(SIZE), capital expenditures (CAPEX), and market liquidity (NOISE).

[Insert Table 4 about here] Table 4 presents results of logistic regressions accessing the weather financial constraints mitigate

the effects of CSR on the pecking order’s financing decisions. While the coefficients on CSR for

financially unconstrainted group are negative and significant (coeff. = - 0.062 and - 0.047, p –

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value = 0.012 and 0.034, respectively), the coefficients on CSR for financial constrained group are

positive and not statistically significant (coeff. = 0.008 and 0.028, p-value = 0.775 and 0.375,

respectively). The results indicate that firms with high CSR are less likely to issue equity when

seeking external financing. The effects of CSR on equity issuance is not pronounced in the group

of financially unconstrained firms. We extend our analysis by considering that financial constraints

may have the first order effect on the pecking order’s financing decisions. We use OLS regression

to examine the effects of financial constraints and the interactions between the CSR score and

financial constraints on the net amount of debt (equity).

[Insert Table 5 about here]

Table 5 presents the results of OLS net debt (equity) regressions on the firm’s CSR

activities. Colum 1 and 2 in Table 5 show the estimated association between DEBT_ISSUED and

CSR score, and the interaction effect of financial constrained dummy variable (FINSCONSTR)

with CSR score. The coefficients on CSR for DEBT_ISSUED as dependent variable are positive

and statistically significant (coeff. = 0.133 and 0.139 with p-value < 0.01): firms with higher SCR

score are more likely to issue debt. The coefficients on the interaction term are negative and

significant indicating that CSR score has a second order effects on debt financing choice. Columns

3 and 4 show the estimated coefficients on CSR and the interaction term between CSR and

financial constraint dummy variable (FINCONSTR). While coefficients on CSR are negative and

significant (coeff. = - 0.366 and - 0.349 with p-value < 0.01), the coefficients on the interaction

term are positive and significant (coeff. = 0.309 and 0.353 with p-value < 0.01). Taken together,

the results suggest that firms with high CSR scores are more likely to follow the pecking order’s

of financing decisions. However, the effects CSR score on the pecking order hierarchy financing

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decisions the second order only compared with the effects of financial constraints regarding the

debt-equity choice in financing decision.

CSR and Underpricing of SEOs

The significant underpricing of SEOs, i.e. the offer price is lower than the closing price on

the day prior to the offer date, is a well-known phenomenon [see, for example, (Corwin, 2003) and

(Mola & Loughran, 2004)]. In this section, we explore whether CSR help reduce the underpricing

if firms raise equity capital to satisfy their financing needs. In our second hypothesis, we

hypothesis that SEO firms with higher CSR are more likely to experience a lower degree of

underpricing through SEO episodes as these firms may exploit benefits from lower information

asymmetry due to a higher reputation in the financial markets. We test this hypothesis in the

following regression:

Equation 4:

SEOUNDERPRICINGi.t = 0 + 1CSRi,t + 2 PRECARi,t + 3BETAi,t

+ 4VOLATILITYi,t + 5 IPOUNDERPRICINGi,t + 6OFFERSIZEi,t

+ 7 RANKi,t + 8TICKi,t + 9 LNPRCi,t X TICKi,t + 10 NASDAQi,t + i,t

where the dependent variable is SEOUNDERPRICING (closing price on the offer day minus the

offer price, divided by the offer price). The main variable of interest is CSR. We expect that CSR

has a negative coefficient if our hypothesis is correct.

Also included in equation (4) is a set of control variables commonly used in the literature

of underpricing of equity offerings (e.g. Corwin, 2003). Specifically, PRECAR measures the pre-

offer price run-up. IPOUNDERPRICING measures the average underpricing (discount) across all

IPOs during the same month as the issue in question. VOLATILITY is a proxy for stock price

uncertainty. OFFERSIZE controls for the effect of price pressure. RANK is (Carter & Manaster,

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1990) underwriter reputation rankings. RANK controls for quality of underwriters2. BETA is a

firm’s beta estimated by the market model using 24-month stock and market returns before the

SEO. TICK is a dummy variable that equals one if the decimal portion of the closing price on the

day prior to the offer is less than $0.25, and zero otherwise. It reflects the effect of rounded prices

on SEO underpricing. NASDAQ is a dummy variable that equals one if the issuers are listed on

NASDAQ at the time of offer, and zero otherwise.

Table 6 Panel A reports the univariate test results for the subsamples of SEO firms where

Group 1 consists of firms with high CSR score in the year prior to a SEO and Group 2 consists of

those that have low CSR score. Panel A shows that the mean levels of SEO underpricing for groups

sorted by two CSR measures are significantly smaller for firms with higher CSR score than for

firms with high low CSR score. The means for high CSR1 group (CSR2 group) are 3.27 percent

(3.33 percent) while the means for low CSR1 group (CSR2 group) are 3.79 percent (3.82 percent),

respectively. The difference between two groups is statistically significant.

[Insert Table 6 here]

Table 6 Panel B shows that the coefficient on CSR from OLS regressions. The coefficients

on CSR are significantly negative both specifications using different CSR scores: -0.012 and -0.13

(p<=0.01). The results provide strong evidence for the hypothesis that issuers with high CSR

scores may be able to get more favorable offer prices and experience less severe underpricing or

value discounting. The signs of coefficients for other control variables are consistent with prior

studies.

2 Data on IPO_undepricing and underwriter’s rank are obtained from Jay Ritter’s website

https://site.warrington.ufl.edu/ritter/ipo-data/

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V. CONCLUSIONS

Investment in CSR brings benefits to firms by reducing information asymmetry, lowering

agency costs and serve as advertising. Prior research find that high CSR firms enjoy the benefits

in both debt and equity markets through a significantly lower cost of debt and lower implied cost

of equity. In this study, we aim to examine the role of CSR in corporate debt-equity financing

choices and the impact of CSR on SEO underpricing when firms choose to raise capital in equity

markets.

Using a U.S. sample of 1,866 firms with 20,894 firm-year observations during the period

1995-2015, we find that high CSR firms tend to use more debt financing and less equity financing

than low CSR firms. We also find evidence suggests that a firm’s decision to raise capital in equity

market is also determined by the level of financial constraints. And financial constraints also

influence the impact of CSR on a firm’s decisions to use debt or equity financing. Our findings

indicate that when a firm is financially constrained, the debt financing option is limited, and the

firm has to turn to equity market to raise capital.

Our predictions and findings are relied on and consistent with the pecking order theory.

The pecking order theory (S. Myers, 1984) explains that due to adverse selection, firms prefer

internal to external finance. When external finance is necessary, firms prefer debt to equity because

of lower information cost associated with debt and equity. Compared to debt issuance, equity is

more rarely issued (Frank & Goyal, 2003). Since high CSR firms are rewarded in both debt and

equity market, the alternative and available options in debt markets would encourage high CSR

firms to use debt financing but to eschew equity financing. The pecking order theory predicts that

firms need to issue equity when their ability to use internal funds or debt financing is limited.

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When firms actually have to raise capital in equity markets, high CSR firms receive

significantly lower SEO underpricing than low CSR firms. Our finding extends the extant literature

on the role of CSR in equity financing by showing a quantified benefit of CSR investment.

Overall, our study enhances our understanding of the role of CSR investment in firm’s

financing decision and the actual cost of equity financing. These results have important and

meaningful implications for companies, regulators, investors.

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Table 1 Descriptive Statistics

This table presents means, standard deviations, the first quartile, medians and the third quartiles of the variables used

in this study for a sample consists of 1,866 firms with 20,894 firm-year observations during the period 1995-2015.

We use the annual scores to construct a composite CSR score for every year and each firm. Particularly, our CSR1

score is measured as total strength minus total concern in MSCI ESG KLD’s five rating categories. We construct a

second measure (CSR2) in a similar vein but excluding corporate governance to disentangle the effect of CSR and

corporate governance. The CSR1 and CSR2 are equally weighted average of five (four) rating categories for the focal

firm for every year in our panel dataset. We follow Bradshaw et al. (2006) to construct net debt and net equity issuance

variables. Net debt issue (DEBT_ISSUED) is the change in total long-term debt during the year. The net debt issue

represents net cash received from the issuance (and/or reduction) of debt. Net equity issue (EQUITY_ISSUED) is the

net amount of cash from issuing and repurchasing equities during the year. Net equity issue represents net cash

received from the sale (and/or purchase) of common and preferred stock less cash dividend paid. SEOUNDERPRICE

is the ratio between the closing price on the offer day minus the offer price, divided by the offer price. KZINDEX is a

measure of financial constraint developed by Kaplan and Zingales (1997), it is the linear combination of five variables

from Kaplan and Zingales (1997): cash flow (CF), Tobin’s Q, debt, dividends, and cash holdings, all scaled by TA

except for Tobin’s Q. More financially constrained firms have a higher KZ index and vice versa. SAINDEX is a

measure of financial constraint developed by Hadlock and Pierce (2010), the index is a combination of asset size and

firm age. By construction, high SAINDEX implies more financially constrained. SIZE is firm size, measured as natural

logarithm of total assets. DEFICIT measures a firm’s financing demand, computed as the sum of common dividends

plus capital expenditures plus the change in net working capital minus cash flow, divided by total assets. ADJRET is

24-month cumulative market adjusted returns. MTB is market-to-book ratio, defined as total assets minus book equity

plus market equity, divided by total assets. PROFIT is profitability, defined as earnings before interest and taxes

divided by total assets. CAPEX is total capital expenditure measured as total capital expenditures divided by total

assets. LEVERAGE is market leverage measured as book debt divided by the result of total assets minus book equity

plus market equity. We follow Hu, Pan and Wang’s (2013) to measure market liquidity by using NOISE variable, this

variable capture different episodes of liquidity crisis of different origins across financial market. BETA is a firm beta,

computed from a regression of firms’ monthly raw returns on the monthly value-weighted market returns over the

rolling five-year window ending in the current fiscal year of the offer date. VOLATILITY is the standard deviation of

stock returns over the period of 30 trading days ending 10 days prior to the offer. IPOUNDERPRICE is the average

underpricing across all IPOs during the same month as the SEO, where the monthly underpricing estimates for IPOs

are obtained from Jay Ritter’s website. OFFERSIZE is Shares offered divided by the total number of shares

outstanding prior to the offer. RANK is underwriter ranking. We obtain underwriter ranking from Jay Ritter’s website.

Ritter refines Carter and Manaster’s (1990) ranking method to construct a new ranking database for major underwriters

and underwriters are ranked based on a 0-9 scale. TICK is a dummy variable taking the value 1 if the decimal portion

of the closing price on the day prior to the offer is less than $0.25, and zero otherwise. NASDAQ is a dummy variable

that takes the value of 1 if a firm’s stock is traded on NASDAQ and zero otherwise.

Variable Mean Std. 25% Median 75%

CSR1 0.067 2.026 - 1.000 0.000 1.000

CSR2 - 0.136 1.979 - 2.000 0.000 1.000

DEBT_ISSUED 57.958 251.742 - 15.630 0.000 52.103

EQUITY_ISSUED - 117.138 290.012 - 85.000 - 5.094 4.116

SEOUNDERPRICE 0.037 0.159 0.020 0.026 0.075

KZINDEX - 18.931 23.181 - 27.964 - 12.196 1.085

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SAINDEX - 3.872 0.684 -4.536 - 4.249 - 3.170

SIZE 6.708 1.794 5.188 6.571 8.132

DEFICIT 0.019 0.198 - 0.105 - 0.015 0.090

ADJRET - 1.904 0.560 - 2.292 - 1.993 - 1.645

MTB 1.971 1.238 1.071 1.427 2.422

PROFIT 0.093 0.097 0.025 0.090 0.158

CAPEX 0.033 0.040 0.003 0.018 0.044

LEVERAGE 0.405 0.286 0.138 0.358 0.655

NOISE 2.896 2.029 1.472 2.275 3.153

BETA 1.277 1.051 0.682 1.157 1.731

VOLATILITY 0.027 0.021 0.013 0.021 0.032

IPOUNDERPRICE 0.150 0.111 0.087 0.136 0.207

OFFERSIZE 0.123 0.110 0.058 0.094 0.154

RANK 8.059 1.275 8.001 8.501 9.001

TICK 0.275 0.447 0.000 0.000 1.000

NASDAQ 0.369 0.482 0.000 0.000 1.000

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Table 2: Pearson Correlation Matrix

This table reports Pearson pairwise correlation coefficients of the selected variables of interest. Two-tail p-values are reported in parentheses. Refer to Table 1 for

details about variable descriptions. *, **, and *** indicates the estimated coefficient is statistically significant at the 10 percent, 5 percent, and 1 percent levels,

respectively.

CSR1 CSR2 DEBT_ISSUED EQUITY_ISSUED SEOUNDERPRICE KZINDEX CSR2 0.949***

(< 0.01) DEBT_ISSUED 0.103*** 0.075***

(< 0.01) (< 0.01) EQUITY_ISSUED - 0.362*** - 0.277*** - 0.288***

(< 0.01) (< 0.01) (< 0.01) SEOUNDERPRICE -0.048 - 0.055*** -0.012 0.055

(0.218) (< 0.01) (0.776) (0.192) KZINDEX - 0.047*** - 0.057*** - 0.013 0.053*** 0.038

(< 0.01) (< 0.01) (0.292) (< 0.01) (0.473) SAINDEX - 0.178*** - 0.135*** - 0.042*** 0.247*** 0.0688 0.270***

(< 0.01) (< 0.01) (< 0.01) (< 0.01) (0.102) (< 0.01)

24

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Table 3: The Effect of CSR on Debt-Equity Choice This table presents the regression results of regressing firm’s corporate social responsibility score (CSR) and other

control variables on the net debt issue (Columns 1 and 2) and on the net equity issue (Columns 3 and 4) for a sample

of 20,894 firm-year observations between the period 1995-2015. Two-tail p-values are in parentheses. Refer to

Table 1 for details about variable descriptions. *, **, and *** indicates the estimated coefficient is statistically

significant at the 10 percent, 5 percent, and 1 percent levels, respectively.

Net(Debt / Equity)Issuei.t +1 = 0 + 1CSRi,t + 2 MTBi,t + 5 DEFICITi,t + 4 LEVERAGEi,t

+ 5 ADJRETURNi,t + 6 PROFITi,t + 7CAPEX i,t + 8 SIZEi,t + 9 NOISEt + i,t

Dependent Variable Net Debt Issue

Dependent Variable Net Equity Issue

CSR1 Measure

CSR2 Measure

CSR1 Measure

CSR2 Measure

(1) (2) (3) (4)

CSR 0.570***

(< 0.01) 0.494***

(< 0.01)

- 0.203***

(< 0.01)

- 0.236***

(< 0.01)

MTB 0.925 0.125 - 0.331*** - 0.318*** (0.710) (0.620) (< 0.01) (< 0.01)

DEFICIT 0.292*** 0.293*** 0.342** 0.351**

(< 0.01) (< 0.01) (0.050) (0.050)

LEVERAGE 0.247** 0.233** 0.553*** 0.493*** (0.050) (0.050) (< 0.01) (< 0.01)

ADJRETURN 0.108*** 0.944*** 0.439*** 0.419***

(< 0.01) (< 0.01) (< 0.01) (< 0.01)

PROFIT 0.227***

(< 0.01)

CAPEX 0.492

(0.390)

SIZE 0.265*** (< 0.01)

0.225***

(< 0.01)

0.423 (0.460)

0.276***

(< 0.01)

0.184

(0.590)

0.709***

(< 0.01)

- 0.918*** (< 0.01)

0.110

(0.750)

0.679***

(< 0.01)

- 0.938*** (< 0.01)

NOISE - 0.721*** - 0.719*** 0.123 0.126*** (< 0.01) (< 0.01) (0.160) (< 0.01)

Year Dummies

Industry Dummies

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Adjusted R2 16.10% 16.10% 39.70% 40.20%

N 20,894 20,894 20,894 20,894

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CSR1 CSR2 CSR1 CSR2 CSR1 CSR2

(1) (2) (3) (4) (5) (6)

CSR - in(1) and

(2) - 0.062**

- 0.047**

- 0.045

-0.015

0.008

0.028

(0.012) (0.034) (0.157) (0.605) (0.775) (0.375)

SIZE - - 0.059** - 0.064** - 0.166*** - 0.175*** - 0.111*** - 0.113***

(0.052) (0.033) (0.001) (<0.01) (0.001) (0.001)

MTB + 0.027 0.027 0.054 0.049 0.078*** 0.077***

(0.367 (0.363) (0.178) (0.216) (0.001) (0.001) MKTLEV 0.134 0.149 0.607* 0.619* -0.387 -0.389

(0.582) (0.541) (0.100) (0.094) (0.130) (0.128)

DEFICIT 0.050 0.046 1.962*** 1.956*** 0.566*** 0.565***

(0.798) (0.816) (< 0.01) (< 0.01) (0.007) (0.007)

ADJRETU RN

0.129***

(< 0.00)

0.132***

(< 0.00)

0.211***

(< 0.01)

0.216***

(< 0.01)

0.130***

(< 0.01)

0.131***

(< 0.01)

PROFIT 0.024 0.019 1.117 1.122 - 1.827*** - 1.829***

(0.953) (0.962) (0.120) (0.119) (<0.01) (< 0.01) CAPEX 3.046*** 3.056*** - 0.012 -0.011 - 4.215* - 4.263*

(< 0.001) (<0.001) (0.991) (0.993) (0.070) (0.067)

NOISE - 0.039* - 0.039* - 0.027 -0.027 0.017 0.016

(0.068) (0.068) (0.325) (0.324) (0.433) (0.443)

Industry

fixed

effects

Yes

Yes

Yes

Yes

Yes

Yes

Table 4: CSR and the Likelihood of SEOs under Financial Constraints This table presents the logistic analysis of the SEO as a function of firm’s corporate social responsibility score

(CSR) and other controlling variables for 3 subsamples partitioned by the level of financial constraints. Firms are in

the low, medium, or high financial constraint subsamples if they have an SAIndex in the top, middle or bottom

terciles of SAINDEX. Two-tail p-values are reported in parentheses. Refer to Table 1 for details about variable

descriptions. *, **, and *** indicates the estimated coefficient is statistically significant at the 10 percent, 5 percent,

and 1 percent levels, respectively.

log L prob(SEOi,t +T ) / (1- prob(SEOi,t +T ))lJ = 0 + 1CSRi,t + 2 SIZEi,t + 3MTBi,t

+ 4 MKTLEVi,t + 5 DEFICITi,t + 6 ADJRETURNi,t + 7 PROFITi,t + 8CAPEX i,t (1)

+ 9 NOISEt + IndustryIndicators + i,t

Expect-ed

Low

Financial Constraint

Medium

Financial

High

Financial

sign Constraint Constraint

- 2Log L 3,814.85 3,816.64 2,597.05 2,598.82 3,535.17 3,534.47

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Table 5: The Effect of CSR and Financial Constraint on Debt-Equity Choice This table presents the regression results when regressing firm’s corporate social responsibility score (CSR),

financial constraints (FINCONSTR), an interaction between CSR and FINCONSTR, and other controlling variables

on the net debt issue (Columns 1 and 2) and on the net equity issue (Columns 3 and 4) for a sample of 20,894 firm-

year observations for the period between 1995 and 2016. FINCONSTR is a dummy variable that takes the value of 1

if a firm’s SAIndex is in the top tercile and 0 if a firm’s SAIndex is in the bottom tercile of the sample. Two-tail p-

values are reported in parentheses. Refer to Table 1 for details about other variable descriptions. *, **, and ***

indicates the estimated coefficient is statistically significant at the 10 percent, 5 percent, and 1 percent levels,

respectively.

Net(Debt / Equity)Issuei.t = 0 + 1CSRi,t + 2 FINCONSTRi ,t + 3CSRi ,t X FINCONSTRi ,t

+ 4 MTBi ,t + 5DEFICITi ,t + 6 LEVERAGEi ,t + 7 ADJRETURNi ,t + 8 PROFITi ,t

+ 9CAPEX i,t + 10SIZEi,t + 11NOISEt + i,t

Dependent Variable Net Debt Issue

Dependent Variable Net Equity Issue

CSR1

Measure

CSR2

Measure

CSR1

Measure

CSR2

Measure

(1) (2) (1) (2)

CSR 0.133*** 0.139*** - 0.366*** - 0.349***

(< 0.01) (< 0.01) (< 0.01) (< 0.01)

FINSCONSTR - 0.013*** - 0.013*** 0.015*** 0.015***

(< 0.01) (< 0.01) (< 0.01) (< 0.01) CSR x FINSCONSTR - 0.126*** - 0.155*** 0.309*** 0.353***

(< 0.01) (< 0.01) (< 0.01) (< 0.01)

MTB - 0.040 - 0.037 - 0.218*** - 0.229***

(0.258) (0.294) (< 0.01) (< 0.01)

DEFICIT 0.209*** 0.209*** 0.372* 0.354*

(< 0.01) (< 0.01) (0.084) (0.102)

LEVERAGE - 0.222 - 0.243 0.012*** 0.118***

(0.17)** (0.139)** (< 0.01) (< 0.01)

ADJRETURN 0.051 0.041 0.343*** 0.375***

(0.375) (0.477) (< 0.01) (< 0.01)

PROFIT 0.122** 0.117** 0.117*** 0.131***

(0.018) (0.023) (0.014) (0.006) CAPEX 0.438*** 0.434*** 0.455*** 0.470***

(< 0.01) (< 0.01) (< 0.01) (< 0.01) SIZE 0.312*** 0.333*** - 0.104*** - 0.111***

(< 0.01) (< 0.01) (< 0.01) < 0.01)

NOISE - 0.036*** - 0.036*** - 0.012 - 0.012

(0.009) (0.010) (0.366) (0.377)

Year Dummies Yes Yes Yes Yes Industry Dummies

Adjusted R2

Yes 7.80%

Yes 7.80%

Yes 46.14%

Yes 45.5%

N 20,894 20,894 20,894 20,894

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Table 6: CSR and SEO Underpricing Panel A of this table presents univariate results of comparing the levels of SEO underpricing of high CSR firms

and low CSR firms. Panel B of this table presents the regression results when regressing firm’s corporate social

responsibility score (CSR) and other controlling variables on SEO underpricing levels (SEOUNDERPRICE). Two-

tail p-values are reported in parentheses. Refer to Table 1 for details about variable descriptions. *, **, and ***

indicates the estimated coefficient is statistically significant at the 10 percent, 5 percent, and 1 percent levels,

respectively.

SEOUNDERPRICEi.t = 0 + 1CSRi,t + 2 PRECARi,t + 3BETAi,t

+ 4VOLATILITYi,t + 5 IPOUNDERPRICEi,t + 6OFFERSIZEi,t

+ 7 RANKi,t + 8TICKi,t + 9 LNPRCi,t X TICKi,t + 10 NASDAQi,t + i,t

Panel A: Univariate Analysis CSR1 Measure CSR2 Measure

Group 1 (Low CSR Score) 0.0379 0.0382

Group 2 (High CSR Score)

Difference (Group 1-Group 2)

0.0327

0.0052***

0.0334

0.0048***

t-value 3.11 2.78

Panel B: Regression Analysis - Dependent Variable (SEOUNDERPRICE)

CSR1 Measure CSR2 Measure Expected sign

(1) (2)

CSR - - 0.012*** - 0.013*** (< 0.01) (< 0.01) PRECAR + 0.006** 0.006***

(0.05) (< 0.01) BETA + 0.002 *** 0.002 ***

(< 0.01) (< 0.01) VOLATILITY + 0.536 *** 0.534 ***

(< 0.01) (< 0.01) IPO UNDERPRICE + 0.018 ** 0.019 **

(0.03) (0.028) OFFER SIZE - 0.015 *** 0.016 ***

(<0.01) (< 0.01) RANK - -0.00 *** -0.004 ***

(<0.01) (< 0.01) TICK + 0.027 *** 0.028 ***

(< 0.01) (< 0.01) LNPRC*TICK - - 0.010 *** - 0.012 ***

(< 0.01) (< 0.01) NASDAQ + 0.008 *** 0.008 ***

(0.001) (0.001) Year Dummies Yes Yes Industry fixed effects Yes Yes Adjusted R2 16.1% 16.1% N 2,761 2,761

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Appendix: Variable Definitions

CSR1 CSR1 score is measured as total strength minus total concern in MSCI

ESG KLD’s five rating categories

CSR2 CSR2 is constructed similarly to CSR1 but excluding corporate

governance to disentangle the effect of CSR and corporate governance.

The CSR1 and CSR2 are equally weighted average of five (four) rating

categories for the focal firm for every year in our panel dataset.

DEBT_ISSUED Net debt issue is the change in total long-term debt during the year. The

net debt issue represents net cash received from the issuance (and/or

reduction) of debt.

EQUITY_ISSUED Net equity issue is the net amount of cash from issuing and repurchasing

equities during the year. Net equity issue represents net cash received

from the sale (and/or purchase) of common and preferred stock less cash

dividend paid.

SEOUNDERPRICE The ratio between the closing price on the offer day minus the offer price,

divided by the offer price

KZINDEX A measure of financial constraint developed by Kaplan and Zingales

(1997), it is the linear combination of five variables from Kaplan and

Zingales (1997): cash flow (CF), Tobin’s Q, debt, dividends, and cash

holdings, all scaled by TA except for Tobin’s Q. More financially

constrained firms have a higher KZ index and vice versa.

SAINDEX A measure of financial constraint developed by Hadlock and Pierce

(2010), the index is a combination of asset size and firm age. By

construction, high SAINDEX implies more financially constrained.

SIZE Firm size, measured as natural logarithm of total assets.

DEFICIT A firm’s financing demand, computed as the sum of common dividends

plus capital expenditures plus the change in net working capital minus

cash flow, divided by total assets

ADJRET Adjusted returns, computed as 24-month cumulative market adjusted

returns.

MTB Market-to-book ratio, defined as total assets minus book equity plus

market equity, divided by total assets.

PROFIT Profitability, defined as earnings before interest and taxes divided by total

assets.

CAPEX Total capital expenditure measured as total capital expenditures divided

by total assets

LEVERAGE Market leverage measured as book debt divided by the result of total

assets minus book equity plus market equity

NOISE Market liquidity, a measure developed by Hu, Pan and Wang (2013) to

capture different episodes of liquidity crisis of different origins across

financial market.

BETA Firm beta, computed from a regression of firms’ monthly raw returns on

the monthly value-weighted market returns over the rolling five-year

window ending in the current fiscal year of the offer date.

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VOLATILITY The standard deviation of stock returns over the period of 30 trading days

ending 10 days prior to the offer

IPOUNDERPRICE The average underpricing across all IPOs during the same month as the

SEO, where the monthly underpricing estimates for IPOs are obtained

from Jay Ritter’s website

OFFERSIZE Shares offered divided by the total number of shares outstanding prior to

the offer

RANK Underwriter ranking, we obtain underwriter ranking from Jay Ritter’s

website. Ritter refines Carter and Manaster’s (1990) ranking method to

construct a new ranking database for major underwriters and underwriters

are ranked based on a 0-9 scale.

TICK A dummy variable taking the value 1 if the decimal portion of the closing

price on the day prior to the offer is less than $0.25, and zero otherwise

NASDAQ A dummy variable that takes the value of 1 if a firm’s stock is traded on

NASDAQ and zero otherwise