Assignment I

SUBMITTED TO Dr. Farooq AS A PARTIAL REQUIREMENT OF THE COURSE

- Advanced Corporate Finance –

Done by:
Nada Lahrech
Assya Chraibi
Naima Fakir

February, 21st 2011

All firms need to raise capital at one time or another to finance new projects, expand
operations, or in many cases, just to start up their business. One of the best ways that newer
and less established companies have found to raise quick capital is to make a stock offering.
This is also known as the initial under pricing practice of investment bankers.

The initial under pricing of the IPO is the difference between the price obtained by the shares
at the close of the first trading day and the price of the offer, adjusting for the market return in
that same period. IPOs are often issued by smaller, younger companies seeking the capital to
expand, but can also be done by large privately owned companies looking to become publicly
traded.

If we assume that the market price of the stock, dictated by supply and demand, is
representative of the company’s value, then the large gain reflects the fact that the IPO issuing
price agreed upon by the underwriter and the firm making the offer is under the actual value
of the firm. However, there is clear and unambiguous evidence that investment bankers
systematically under price IPOs in order to raise capital and attract a significant number of
investors.

The pricing of a company’s stock in the IPO is greatly dependent on which of these entities
possess perfect information about the issuing firm, and which entities must rely on the others
to report the information to them. The latter must rely on signaling to infer the true value of a
stock and must give the more informed entities incentive to provided accurate data about the
firm’s true value. The IPO price is agreed upon and it may or may not reflect the actual worth
of the company.

On the other hand, behavioral finance offers several possible explanations for the under-
pricing phenomenon. Several theoretical models have been developed, and each has gained
some empirical support. Perhaps the most obvious reason that underwriters choose to
systematically under-price new stock is to make it easier for them to market the issue.

This intentional under-pricing will reduce the chances that the issue will be undersubscribed,
resulting in capital loss to the underwriters. If the offering is undersubscribed, the underwriter
may be forced to reduce his inventory of shares. Aversion to loss may influence the pricing
behavior of IPOs by the underwriting firm. Usually, underwriters (investment bankers) are
risk averse. Without the ability to hedge the risk of holding the issuing firm’s stock, it is
difficult to shift the risk to another party through derivatives. Therefore, there is strong
incentive for the underwriter to under price the IPO.

In the same optic, even if issuers are loss averse, they are not disturbed by the IPO under
pricing since their gain from the sale of their shares when going public is significantly high
relative to the losses from the under pricing. Issuers irrationally aggregate the two producing
an increase in their wealth.
 References

Adams, M. and Thornton, B.(April 2008). IPO Pricing Phenomena: Empirical Evidence Of
Behavioral Biases. Journal of Business and Economics Research ,(6), 4.

Han, B. and Hsu J.(December 2004).Prospects theory and its application in finance.