Question

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)

Answer 1

1. Under priced (%)- 0.50/6= 8.33%

Over priced (%)- 0.3/6=5%

2. Expected profit- 0.50*2,000= 1,000 $

As probability is about 60%, there is high chances of making this profit. Further, bankers are able to distinguish so subscription level also endorses the investor view

3. Expected profit is 0.50 per share alloted in IPO for uninformed investor. Since, investor is uninformed, he would expect this profit to accrue to him my receiving shares in allotment. Hence, total profit would be 800*.05= 400$

4. Expected profit would be = 0.20*800= $160

Underpricing percentage - 0.2/6=3.33%

5. Winner's curse is outbidding in the IPO to get allotment and outbid price far exceeds the intrinsic value. s a result, the largest overestimation of an item's value ends up winning the auction. In this example, the investors would outbid the shares in expectation of undervaluation leading to increasing bid price resulting in over estimation far above the intrinsic value.

One prominent empirircal observation on undervaluation of IPO is information asymetry. The information asymmetry theory assumes that the IPO pricing is a product of information disparities between seller and buyer. COmpany offering IPO is uncertain of investor's reception and leading to IPO underpricing by the Company to sail it through for meeting regulatory requirements.