Chapter 10.4 Flashcards
IPO Pricing and Cost
Why does tension arise between the issuer and the underwriters when the final offer price for the stock is being determined?
The issuer prefers the stock price to be as high as realistically possible. In contrast, the underwriters prefer some degree of underpricing
What is underpricing?
Offering new securities for sale at a price below their true value
Why do underwriters prefer a lower offering price in an IPO?
Because the lower the offering price, the more likely the securities will sell out quickly, and the less likely the underwriters will end up with unsold inventory
Why do investment bankers argue that some underpricing will provide stability for the stock prince once the secondary market for the shares is established?
Because it helps attract long-term institutional investors. These investors will not sell, or flip, the shares as quickly, their presence reduces price volatility
Why is it important for both issuers and underwriters to agree on an appropriate IPO price?
In reality both face potential costs if the stock price is too high or too low
What happens if the stock is priced too high?
- The entire issue will not sell at the proposed offer price
- There can be considerable uncertainty about what the true value of the shares is since they haven’t yet traded in the public market
What can contribute to the pressure of setting a lower stock price?
Considerable uncertainty about what the true value of the shares is since they haven’t yet traded in the public market
In a firm-commitment offering, who will suffer a financial loss if the offer price is set too high?
The underwriters
In a firm-commitment offering, who will raise less money than expected if the price is set too high?
The issuing firm
Who will experience an opportunity lost if the stock is priced below its true value?
The firm’s existing stockholders; the firm will receive less money for the stock than it’s worth
What consequences does the investment banking firm suffer if the underpricing is significant?
Suffer a loss of reputation for failing to price the new issue correctly and raising less money for its client than it could have
In practice, what do most market participants agree on when it comes to pricing?
That some underpricing is good for both the issuer and the underwriter. However, the question of how much underpricing is appropriate is open for debate
Data from the marketplace shows that the shares sold in the IPO are typically priced how many % below the price at which they close at end of the first day of trading. what does this imply?
10-15% below. Implies that underwriters tend to sell shares of stock in IPOs to investors for between 90-85% of their true market value
In Snap’s 2017 IPO, the company sold 200 million shares at $17 each. The stock closed at $24.48 on the first trading day. What does this reveal about the cost of underpricing?
The stock was underpriced by $7.48 per share ($24.48 − $17.00 = $7.48). They raised $3.4 billion in total, but they could’ve sold for $1.496 billion ($7.48 per share × 200 million shares = $1.496 billion) more.
Who receives the extra value of underpriced stocks?
Goes to pockets of new investors who bought the shares allocated by the underwriters of the IPO
What is average first-day return a measure of?
The amount of underpricing
From 1997-2016 (excluding 1999&2000) what was the weighted average first-day return?
~13.1%, although there’s considerable variation on a year-by-year basis
Why was the avg underpricing of issues during last 16 years from 2001-2016 13.1%, while the avg during 1999-2000 was 63.7%?
858 total IPO offerings were sold during 1999 and 2000, in both yrs the total amount of money raised through IPOs was unusually high.
Bc of the underpricing, ~ $66.9 billion was left on the table (not received by the companies making the offerings or their selling shareholders) during these two years.
What does the term “left on the table” refer to in the context of IPO underpricing?
It refers to the money that companies could have raised if shares were priced closer to their first-day closing price—in 1999–2000, this amounted to $66.9 billion.
What are the 3 basic costs associated with issuing stock in an IPO?
- Underwriting spread
- Out-of-pocket expenses
- Underpricing
How is underwriting spread a basic cost associated w/ issuing stock in an IPO?
The underwriting spread is the difference between the proceeds the issuer receives and the total amount raised in the offering.
How are out-of-pocket expenses a basic cost associated w/ issuing stock in an IPO?
Out-of-pocket expenses include other investment banking fees, legal fees, accounting expenses, printing costs, travel expenses, SEC filing fees, consultant fees, and taxes. All of these expenses are reported in the prospectus
How is underpricing a basic cost associated w/ issuing stock in an IPO?
Underpricing: the difference btween the offering price + the closing price at the end of the 1st day of trading in the public market. It’s the opportunity loss that the issuer’s stockholders incur from selling the security below its true market value
What is considered a smaller IPO?
Less than $40 million
How are costs associated with IPOs different for smaller IPOs (less than $40 million)?
Costs associated with underpricing are relatively small; however direct costs comprise a much larger fraction of the total value of the issue
What are the avg direct costs for IPO deals valued at <$10 million and how does it compare to underpricing?
16.6% of the valye of the issue, while underpricing is negligible
How do IPO costs change for larger deals compared to smaller ones?
Underpricing becomes more significant for larger IPOs, but they benefit from economies of scale in direct costs, meaning the cost percentage decreases as deal size increases.
