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What is the incentive of an investment banker to choose a fair price for a new
security issue?
Pricing a new security is extremely difficult
Investment banker has better information and ability to choose fair price than
anyone else
If investment banker on average prices issues too high, buyers in the future
will not want to buy from that banker
If investment banker on average prices issues too low, issuers in the future will
not want to use that investment banker
Reputation of investment banker should provide them with an incentive to
price issues accurately
Do investment bankers on average price IPOs fairly?
Answer- NO!
Underpricing
Fact:
For U.S. IPOs conducted between 1960 and 2007, the average first day return is 18%.
Denmark
Canada
Netherlands
Spain
Turkey
France
Australia
Norway
Hong Kong
UK
USA
Italy
Japan
Singapore
Sweden
Taiwan
Germany
Switzerland
Korea
Brazil
India
China
256 %
20
40
60
return (percent)
80
100
Underpricing (continued)
How should issuers feel about this underpricing?
Uninformed investors:
willing to buy 1 million shares at a fair price
assess true value of the shares at: $10 with prob.=.5
$12 with prob.=.5
Informed investors:
know if the shares are worth $10 or $12
willing to order 1 million shares if offer price is less than the true value
Basic lesson:
At what price P will the entire issue sell? Choose P so that:
Example
Company A
Market believes shares worth
$90 with probability .5
Company B
Market believes shares worth
$90 with probability .5
Observations:
Market realizes that a firm that issues equity is worth less than their current price
Market will only pay $70 per share to firms that announce they want to sell equity
May be no credible way for Company A to convince market that shares are really
worth $90
Anticipating this market reaction, company A will probably choose to either use debt
or else to pass up investment projects
Implications
1. Explains preference for debt over equity when accessing external capital
markets
2. Same argument implies preference for retained earnings over new debt
issues
3. Explains why profitable firms have low debt. They can finance investment
entirely from retained earnings
4. Indicates that there is value to having financial slack- cash, marketable
securities, unused bank lines of credit.
5. Missing out on positive NPV projects because of external financing
problems can be quite expensive.
$860 billion
$207 billion
$1,067 billion
$751 billion
$1,067 $751 = $316 billion
$469 billion
-$153 billion
$316 billion
This seems to be highly consistent with the pecking order theory of financial
choices.
1. Underwriter spread