Question

Problem 1: A company is going public at $16 and will use the ticker XYZ. The underwriters will charge a 7 percent spread. The company is issuing 20 million shares, and insiders will continue to hold an additional 40 million shares that will not be part of the IPO. The company will also pay $1 million of audit fees, $2 million of legal fees, and $500,000 of printing fees. The stock closes the first day at $19.

The company in Problem 1 grants a 15 percent overallotment option to the underwriter. The underwriter issues shares that are backed by the entire overallotment option but has not yet exercised the option. a. Explain what will happen if the price of the stock increases to $22. Describe the underwriter profits from the overallotment option in your explanation.
b. Explain what will happen if the price of the stock decreases to $11.50. Describe the underwriter profits from the overallotment option in your explanation.

Answer 1

Brief Explanation:

Overallotment option is also called Green Shoe Option.

Under a Greenshoe option/overallotment option the underwriter of an IPO has the right, but not the obligation to buy shares from the issuer at the issue price.

Thus the underwriter can sell additionally 3.5 Million shares under the overallotment option. however, the underwriter does not have these shares to sell, so it effectively shorts the shares (sells shares it does not have). It owes these shares to the investors,and it must deliver these shares to the investors. The underwriter will need to obtain the shares from somewhere in order to close its short position.

Solution

a) If the price of the share increses to $ 22, The underwriter since have sold excess of 3 million shares needs to cover their short position by purchasing from the open market at $ 22, and thereby incurring losses, however since the underwriter has overallotment option, they will exercise that , buy the shares from company at $ 16 and fulfill it's short obligation at $ 16. The overallotmnet will increase supply and overallotment option will thus bring price stability.

If the share price increases to $ 22, and the overallotment option is exercised by the underwriter, it will purchase the additional 3.5 Million shares from the company at $ 16, the issue price and fulfill it short obligation.

Thus the underwriter will neither gain nor loose exercising the overallotment option. Underwriter will receive their commission at 7% spread on entire issue.

b) If the share price drops it may indicate that the shares are unrealiable, thus in this case the underwriter buy back the shares and returns it to the lender (issuer) thus reducing the supply of shares in market.

If the Price of the stock decreases to $ 11.50, the underwriter who has sold additional 3 million shares will make profit, since the shares were sold for $ 16, however the price prevailing is $ 11.50,

Thus profit = ($16-$11.50) = $ 4.50 per share i.e 3*$4.5= $13.5 million.