Advertising intensity, investor recognition, and implied
cost of capital
Steven X. Wei
Published online: 13 February 2011
Ó Springer Science+Business Media, LLC 2011
Abstract The main purpose of this paper is to test Merton’s (J Finance 42(3):483–510,
1987) hypothesis that better investor recognition is correlated with lower expected returns.
We measure investor recognition with the ﬁrms’ advertising intensity and offer consistent
evidence that higher advertising intensity is associated with lower implied cost of capital,
as derived from Value Line target prices and dividend forecasts. Investor recognition plays
an important role in attracting investors, improving liquidity, and ultimately reducing the
cost of capital. The ﬁndings shed light on the capital market implications of advertising
expenditures and complement the extant research on investor recognition.
Keywords Advertising Á Investor recognition Á Implied cost of capital
JEL Classiﬁcation G14 Á M37
Merton (1987) develops a model of equilibrium under incomplete information showing
that ﬁrms that are unfamiliar to investors exhibit low liquidity and have high expected
This paper attempts to test the relationship between investor recognition and stock
expected returns by examining the association between a ﬁrm’s advertising intensity and
the implied cost of equity capital.
Y. Huang (&) Á S. X. Wei
School of Accounting and Finance, The Hong Kong Polytechnic University,
Hung Hom, Kowloon, Hong Kong
S. X. Wei
Speciﬁcally, he conjectures that ‘‘[the] model provides a rationale for expenditures on advertising about
the ﬁrm that is targeted for investors and on public relations designed to generate stories about the ﬁrm in the
ﬁnancial press’’ (Merton 1987, p. 501).
In the paper, we use implied cost of (equity) capital and ex ante cost of (equity) capital interchangeably.
Rev Quant Finan Acc (2012) 38:275–298