IPO underpricing: causes, costs, and effects on firms and investors

IPO Qs

What is the IPO under pricing and why might is persist?

IPO under pricing is the practice of the investment bank or banks serving as the underwriter(s) for the IPO selling to the people and institutions on the IPO list at a price below the expected market value of the stock (Carey, 2008). Though this occurs ostensibly because it is not possible to accurately peg the market price of an unlisted stock and because it is necessary to reduce risk, research shows that it more likely persists because it creates substantial profits for the initial investors who are strong clients of investment banks (Carey, 2008).

What is the relationship between IPO and underpricing? (What will increase or decrease? How that will help to raise capital and benefit company and investors)?

When underpricing occurs, the price of the initial stock purchase -- which is the only money that goes to the firm actually issuing the stock -- is lower, meaning that more shares of equity have to be sold in order to meet the necessary level of capital attainment (Carey, 2008). Again, this has benefits for any investors that is actually able to purchase the stock at the IPO price, including many officers and possibly other employees at the company, but leads to (in direct terms of capital acquisition, at least) a reduction in value for the company.

3.

Why is under pricing a cost to the issuing firm?

Underpricing is listed as a cost to the issuing firm because, quite simply, they are selling shares of equity in the firm at a cheaper rate than they could actually acquire on the open market, and the difference in the market value of the equity and the capital the company actually receives can be seen as the cost of performing an IPO with investment banks as direct partners and institutional investors as indirect partners (Carey, 2008). In other words, to guarantee the capital acquisition, the firm pays a premium for IPO assistance and major investor participation.

4.

Explain, it may be difficult to price an IPO because there isn't a current market price available. How this will affect the company and investors?

As with prices in any other free market, the price of shares in companies that are traded on an open public stock market is basically set by supply and demand, with price increasing as demand increases (given the relatively constant supply of a given stock on a day-to-day basis). Because an IPO is specifically an initial public offering of stock, there has been no supply in the market and no meaningful demand in a market setting, and thus determining the price can be hard. This affects the company and investors by creating a reliance on the underwriting syndicate in setting the price, which gives entrance to other agents and forces (Carey, 2008).

5.

How can underpricing benefit shareholders and investors?

Again, underpricing only creates benefits for those investors that are able to obtain the stock at the below-market price (the underpriced price), and really does not benefit those that are already shareholders in the company.

d.

Do under pricing benefit the company? Or leads the company to suffer to raise capital from financial market?

Underpricing leads a company to suffer in its attempts to raise capital from the financial market, though this suffering or cost might at times be necessary to incentivize the IPO and guarantee capital acquisition.

Reference

Carey, W. (2008). Who Profits from IPO Underpricing? Accessed 16 April 2012.

http://knowledge.wpcarey.asu.edu/article.cfm?aid=479