IPO Cost and Pricing
Underpricing
Besides the substantial underwriting cost and direct costs of lawyers, printers, accountants, etc., the IPO firm has to bear notional losses due to the underpricing of the issue—i.e., the IPO price is less than the true price of the stock. If the offering price is less than the true value of the issue, original stockholders effectively provide a bargain to the new investors. The finance literature shows that investors that buy at the issue price on average realize high returns (for example, 18%) over the following days. This high return from underpricing is common across the world—especially in China, which provides the highest return of 257% (Loughran, Ritter, and Rydqvist, 1994).
Underpricing, which is most likely to be seen with the bookbuilding method, can be justified as follows. First, a low offer price makes it probable that shares will later be traded at a higher price in the market, thus enhancing the firm’s ability to raise capital in future. That is, underpricing ensures that the IPO is successful and that those who want to buy the issue will follow the same underwriter among those in the market. Second, it is a way to avoid the winner’s curse—the feeling of investors that they have paid too much. Simply, underpricing makes it more likely that an IPO will be successful. It appears that stockholders of the IPO firm focus more on likely gains in wealth from later stock price increases than on any short-term loss from underpricing (Loughran and Ritter, 2002).
New Price and Stock Issue
Suppose that an IPO firm has 10 million shares with a current valuation of $100 million, that it wants to raise $70 million for the issue, and that it has to pay $4.9 million for the direct cost of issuance, which is in general about 7% of the issue value (Hansen, 2001). The post-issue price, Pnew, which includes underpricing, and the number of new shares to be issued, N, will be determined simultaneously. That is, the dollar amount of the new issue will cover the fund required and the direct cost to be paid, while the augmented value of the firm will include the old and new assets of the firm. Pnew and N can be determined as follows:
Pnew × N = $70,000,000 (new fund) + $4,900,000 (issue cost)(1)
(10,000,000 + N) × Pnew = $100,000,000 (old assets) + $70,000,000 (new assets)(2)
Solving these two equations (1) − (2) yields the new price of the IPO, Pnew = $9.51. The number of new shares to be issued, N = 7,875,920.
Making It Happen
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An IPO is a time-consuming process.
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The success of an IPO depends on the successful selling of the firm to the investment banks, to the regulator, to the analysts, and to the public.
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During the six-month IPO process the firm’s operations need to be on autopilot cruise control as management will be totally tied up during this time.
Notes
1 See Wall Street Journal (December 8, 2008).
2 See International Herald Tribune (January 1, 2008).
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