Question

From a transaction cost perspective, discuss why a firm may contract with an investment bank to underwrite or place an issue.

Answer 1

first let us understand what a transaction cost is

It is the expenses incurred when buying or selling a good or service.

The transaction costs to buyers and sellers are the payments that banks and brokers receive for their roles.

Transaction costs are important to investors because they are one of the key determinants of net returns. Transaction costs diminish returns, and over time, high transaction costs can mean thousands of dollars lost from not just the costs themselves but because the costs reduce the amount of capital available to invest

In a firm commitment, an underwriter acts as a dealer and assumes responsibility for any unsold inventory. For taking on this risk through a firm commitment, the dealer profits from a negotiated spread between the purchase price from the issuer and the public offering price to the public

The reason why the firm will approach an investment bank is simply because of the distribution network and access to clients who can buy the issuance.

Suppose that a private company XYZ wants to get an IPO, if they do not approach an investment bank, they will have to bear a lot of cost in sales and they might not even be able to sell the complete issuance.

Hence even from a cost perspective, the company would want to approach an investment bank for underwriting