Incentives To Underprice

Incentives to under price вЂ" Accounting and Finance Journals

This journal written by Grame Camp, Aimee Comer and Janice C.Y. How, is an in-depth analysis of share pricing and directly relates to IPO’s (Initial Public Offerings) and how often under pricing your shares initially doesn’t detract from overall net worth and in fact can lead to greater increases in wealth due to future economic benefits gained from shareholder support and confidence as a result of the initial sale of shares at a loss. This theory is primarily supported by Rock (1986), Habib and Ljungqvist (2001) and Barry (1989) who have all got works published on this matter.

Under pricing of IPO’s is a very common practice, studies show that under pricing ranges from 4.2 per cent in France to upwards of 80.3 per cent in Malaysia. Under pricing is frequently described as �money left on the table ,’ with the implication that the issuer incurs a wealth loss from trading the IPO shares at a reduction. Ljungqvist suggests that the choice issuers make at the IPO are strategic as they generate a wealth benefit in the aftermarket which ratifies the wealth loss suffered from the offering. The theory as supported by Ljungqvist is that �higher direct issue costs associated with an issuer’s choice to book build are traded off by a lower level of under pricing. This in turn impacts on wealth through the level of ownership retention. Focusing on increased trading volume in the immediate aftermarket as a wealth benefit from the IPO, the results support the notion that the choices issuers make at the offering generate a compensatory benefit in the aftermarket. Specifically, issuers’ choices that result in higher under pricing and wealth loss also result in higher trading volume in the aftermarket .’

In its most simple form the reason a company enters into the stock market to begin with is to refinance the firm and to obtain new funds, this will lead to added liquidity in their investments and diversification in their portfolio. It is for these gains that you can see why the choices businesses make at the offering (under pricing) may seem unfounded when considered on its own, but when viewed within the multidimensional menu of options they seem rational. It really is crucial therefore to highlight the need to consider issuers’ wealth in the perspective of all the choices they make, not only in the view of one alternative such as the offer price and, therefore, under pricing.

This journal comes to conclusions made through Barry’s (1989) wealth loss metric (WLTH) which is an estimate of the percentage change in wealth for the issuer from the IPO. Barry used many different variables and measures to calculate this, including offer price, promotion costs, percentage of shares retained by vendors from the prospectus the number of shares offered and the offer mechanism, once he had these figures he was able to make two more metrics, these were called ALPHA and UPR. ALPHA is the number of shares retained by pre IPO вЂ" shareholders divided by the total number of shares outstanding post IPO, and UPR which is the conventional percentage change between the closing market price on the first day of listing and the final offer price.

Once he had these three variable metrics he was able to see how they related and how they affected wealth distribution through the IPO’s. In releasing the shares the issuer can choose either a fixed price offer or a book вЂ" build offer. Book вЂ" build offers allow the organizing broker and the issuer to obtain information from investors in the period before the issue. It is a costly process to gather the information however it means the offer can be more accurately priced so that a lower level of underpricing occurs. The advantages are apparent for the issuer and in that way you could say it justifies the higher issue costs of a