Question

Which of the below are possible reasons for why some IPOs are underpriced [i.e., the price rises a lot on the first day]?

It is necessary to compensate investors for risks of buying the security, including both “market timing” by firms and the “winner’s curse”

To minimize the underwriter fees paid by the issuer and maximize the amount of capital the firm is able to raise

Because of a conflict of interest between underwriters and the issuer

Only (a) and (b)

Only (a) and (c)

All of the above

Answer 1

The Correct answer is Only (a) and (c), Let me explain why

(a) It is necessary to compensate investors for risks of buying the security. The investors are encouraged to invest in the company's stocks, by underpricing the shares during an IPO. There is a lack of historical trading data, as the shares are being newly listed. So, the IPO is considered as risky by them. For this reason, encouraging them by underpricing is possible.

Winner's curse means that uninformed investors tend to invest in any IPO, whereas informed investors invest in IPOs only when their perceived fair value exceeds the share price offered in IPO. Thus they have an advantage in the market. But, the informed investors can't absorb the IPO offerings alone, as they have limited capacity. So, the company may underprice the share, so that both the uninformed as well as informed investors invest in the IPO, thus eliminating the winner's curse.

Hence, the statement is a possible reason for underpricing.

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(b) Every company would like to receive as much price as possible from the IPO, as it will increase their capital. Thus, the amount of capital a firm is able to raise will be higher when the price per share is higher. So, there's no reason of underpricing for this reason.

Further, underwriter's fees paid by the issuer is a substantial IPO cost for the issuer, but it is still a small percentage of the capital the firm can raise by issuing shares in the IPO. So, there's no gain from saving underwriting fee, if there's a greater opportunity cost of receiving less proceeds due to underwriting.

Hence, the statement is not a possible reason for under-pricing.

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(c) The issuer always wants to raise higher proceeds from the IPO. The underwriter is surely going to get the underwriting fees, but it will be easy for the underwriter to sell the shares at a lesser price, thus leading to underpricing of the IPO. Further, if the shares are not fully allotted,then the underwriter may have to purchase the remaining shares, as per their agreement with the issuer, during the book building process. (bought deal).

Thus, to minimize the risk, the underwriters often prefer to underprice the IPO.

Hence, the statement is a possible reason for under-pricing.

Answer: Onlt (a) and (c)