Question

Question 5

The firm Ragnar has announced an initial public offering of shares (IPO). The shares are being offered in the IPO at a price of $6 each. All potential investors know that at this price the share is either undervalued by $0.50 (probability 60%) or overvalued by $0.30 (probability 40%). ‘Informed’ investors such as banks are able to distinguish whether the share is overvalued or undervalued. ‘Uninformed’ investors are not able to do this. Demand from uninformed investors is sufficient to take up all the shares offered in the IPO. If the demand for the shares is greater than the number offered, the shares will be rationed. You are an uninformed investor with $12,000 to invest. If rationing occurs you will only be able to buy 800 of Ragnar’s IPO shares.

(a) By what percentage is the IPO underpriced/overpriced?

(b) What would be your expected profit if you were able to buy 2,000 of the IPO shares? Do you expect to be able to do this? Why/why not?

(c) As an uninformed investor, what is your expected profit from participating in the IPO?

(d) What would your expected profit be if the undervaluation is only $0.20 per share instead of $0.50, and everything else unchanged? What is the underpricing percentage now?

(e) Explain what is meant by the ‘winner’s curse’ in the context of IPOs, with reference to your answers for the previous parts of the question. Briefly discuss one other possible reason for the empirically observed underpricing of IPOs. (140 words)

Student: I know the policy of chegg is only for 4 sub parts, i would be grateful if you can give a few words on part (e) too.

Answer 1

(a) By what percentage is the IPO underpriced/overpriced?

IPO Price = $6

Probability of Undervaluation = 60%

Undervalued by $0.50

Probability of Overvaluation = 40%

Overvalued by $0.30

Fair Price = IPO Price + Undervalued Price - Overvalued Price

= $6+($0.50*60%)-($0.30*40%) = $6+$0.30-$0.12 = $6.18

Thus the IPO is undervalued by $0.18 ($6.18-$6) or 2.91% ($0.18/$6.18)

(b) What would be your expected profit if you were able to buy 2,000 of the IPO shares? Do you expect to be able to do this? Why/why not?

Number of shares bought = 2,000

Because the IPO price is undervalued, it is expected that the price will move to its fair price of 6.18 after the IPO returning a profit of $0.18 per share.

Hence, the expected profit = 2,000 shares * $0.18 = $360

It is mentioned that demand from uninformed investors is sufficient to take up all the shares offered in the IPO. Further, because the IPO price is undervalued, informed investors like banks will also apply for the IPO resulting in the demand for the shares being greater than the number offered and hence the shares will be rationed. If the shares are rationed, only 800 shares can be bought instead of 2,000 shares.

(c) As an uninformed investor, what is your expected profit from participating in the IPO?

As an uninformed investor and also since the chances of shares getting rationed in high, only 800 shares can be bought. Hence the expected profit is 800 * $0.18 = $144

(d) What would your expected profit be if the undervaluation is only $0.20 per share instead of $0.50, and everything else unchanged? What is the underpricing percentage now?

IPO Price = $6

Probability of Undervaluation = 60%

Undervalued by $0.20

Probability of Overvaluation = 40%

Overvalued by $0.30

Fair Price = IPO Price + Undervalued Price - Overvalued Price

= $6+($0.20*60%)-($0.30*40%) = $6+$0.12-$0.12 = $6.00

Thus the IPO is the same as fair price of $6. Thus, there is no underpricing or overpricing. Hence no profit can be expected .

e. Explain what is meant by the ‘winner’s curse’ in the context of IPOs, with reference to your answers for the previous parts of the question. Briefly discuss one other possible reason for the empirically observed underpricing of IPOs

Winner's curse is a theory generally applied in auctions as per which the winner of a bid will pay a price higher than the fair price. The same concept is applied in IPOs. Since the fair price of the share in a IPO is not known, uninformed customers tend to bid at a higher price than its fair price while the informed customers will act according to the knowledge they gather. This invariably results in uninformed customers getting more customers at a price higher than the fair price. In the given question, the probability of undervalued is 60% and hence majority of the investors believe the IPO price is under-valued and hence bid at a higher price and this invariably increases the price of the share much higher than its fair value.

IPOs generally tend to be underpriced. One Possible reason is that firm offered its shares in IPO have to price the shares at a discount so as to attract the uninformed investors to purchase the issue.This is because uninformed customers do not posses the same information as of the informed customers. While informed customers participate in an IPO if they believe its underpriced basis the information they possess, uninformed customers participate basis their own study or expectation. In order to generate maximum participants to the IPO, it is generally under-priced so as to attract both informed and uninformed investors.