Initial Public Offer Under-Pricing - Assignment Example

IPO Under-Pricing xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Name xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Course xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Lecturer xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Date Initial Public Offer Under-Pricing According to Ljungqvist (2007), IPO under pricing is pricing of IPO stocks below the market value of the stocks. Under pricing happens when the offer price of the stocks is lower than the price of the stocks on the first trading day. The under pricing is only short-term because the supply and demand laws eventually drive the prices towards the intrinsic value of the shares (Sherman & Titman, 2002). Mostly, the IPOS are under priced because of the concerns relating to uncertainty and liquidity about the level at which the shares will trade. Pham et al. (2003) suggest that, the less predictable and liquid shares are, the more underpriced they are in order to compensate for the risk they are undertaking. A firm under prices its shares in order to encourage investors to purchase its shares during the IPO. In most cases, the issuer of IPO has more information than the investors and thus the reason for under pricing. As Da Silva et al. (2003) underpins, under pricing of IPO is not unique to the US market, this is a phenomenon that is experienced internationally and especially in well developed stock markets. In Australia, IPO under pricing is depicted as symmetry with a cogent expectations structure. Institutional differences and pricing procedures appear to play a significant role in the height of initial returns in the Australian market as (Bayley et al., 2006) underpins. However, their influence in the succeeding price behaviours is less apparent. Essentially, as Dimovski & Brooks, (2006) explains, IPOs in Australia are under priced by 25.47% for abnormal returns and 26.43% for raw returns on the first trading day in the stock market. This indicates that short term IPO under pricing is not a unique phenomenon to the United States firms only. This scenario or phenomenon exists in the Australian stock market. Question 2 (Calculations in appendix 1) The returns from the initial public offer of the companies that went public between November 1st 2009 and October 31st 2010 are indicated. The returns indicate a massive under pricing of the IPOs by the issuing companies. The initial return is the best way of indicating how the firms under priced their stocks on IPO. The initial returns of the most of the companies under study give negative results of the initial return. It is very important to note that not all firms that were listed in the Australian stock exchange at the given date had short term IPO under pricing. Some of the firms valued their stocks well and they did not take advantage of information asymmetry to make abnormal gains during the IPO. Proper and appropriate valuation of the shares of a firm is very important during the initial public offer. The firms that register a negative initial return are an indication that they did not under price their stocks during IPO. The initial returns are negative because the stock’s closing price traded at a lower price than the offering price and hence the investors did not make gains from trading in the stocks on the first day of trading. The investors did not make any gains by trading the stocks rather they made losses. This is an indication of overpricing of the shares. On the other hand, the initial returns are positive because the shares closing price traded at a higher price than the offering price on the first day of trading in the exchange market. This is an indication that the shares were undervalued and under priced during the IPO. As a result, the investors who traded on the first day of the IPO make gains. For under pricing, like some companies in this analysis, the IPO issue price do not reflect the intrinsic value of the shares and therefore the shares rise up to reflect the real value. The underwriters make abnormal gains when the shares are under priced. Short term under pricing of IPOs is a disadvantage to the uninformed investors. They do not have information about the issuing company and they purchase shares without knowing if they are investing in a company with what value (Ljungqvist et al., 2002). The mean of the initial returns is a negative value. This indicates that most of the company's IPO were under priced. The median of the initial return also gives the same value with the mean meaning that they are closely related. This is a strong indication of short term IPO under pricing for these companies in the Australian stock exchange market. In addition, the under pricing may also be because of mistakes and errors during the auditing of the IPO. Usually, these errors are very risky because they fail to detect the accounting errors make during the preparation of the IPO by company accountants and auditors. Most companies drop in their performance after IPO. Firms that drop in their performance are affected by loss of investors’ confidence especially if the company was performing very well before the IPO. Loss of investors’ confidence makes the shares of the company to soar down and consequently the company's performance in the exchange market goes down. Stock market experts attribute decline in performance level to loss of investors’ confidence as well as under pricing. It is therefore very important for the management to work in building the investors’ confidence. The companies whose IPO’S have been calculated can be categorized to three major industries which are; the service industry, finance industry and the mining industry. For the groupings it is assumed that these classifications are based on the nature of activities carried out in these industries. The mining industry comprises of those companies dealing with extraction and processing of mineral and resources. The service industry is made up of all companies listed and deal with provision of varied services such as education and technological services among others. The finance industry facilitates financial and investment management. The mining industry listed and maintained most of the industries in the Australian stock exchange. This is an indicator of good performance in the mining industry. The service industry has the least number of companies in the Australian stock exchange which means that the performance is not as good as it was in the mining industry. He issue price for the shares in the mining industry is 0.2 for most companies. This reflects stability in the market performance of the mining industry. This also makes the market predictable so that even in the expectation to invest in this industry one will expect to get the shares trading at the same price. The assumption made to describe the consistency in issue price of the mining industry is that the shares trading in the different companies in the industry are not competitive. The issue price for most companies in the service industry was also observed to be above 1 while for companies in the finance industry their issue price was very high. The last trading prices for companies in the mining industry and the finance industry have registered an increase from the issue prices. This shows growth in the market value for these shares. The maximum and minimum initial return realized in the industry are from the service industry this indicates that the companies in the service industry are performing at both extremes. This analysis is made with the assumption that all companies registered as limited operate in the service industry. Question 3 Theories/propositions that provide the most plausible explanations for the occurrence of short-run IPO under-pricing in the US or Australian stock market Information Asymmetry Lowry & Shu (2002) explain that this is the most prominent theory that provides the most plausible explanations for the occurrence of short run IPO under pricing in US or Australian market. This theory contains the most empirical support that under pricing of initial public offer occur because of information asymmetry. This theory also assumes that the pricing of the IPO is because of disparities in information. Many people take a variety of forms in this theory but the most influential form is the one that was put forward by Kevin Rock. It asserts that investors who are not informed bid for IPO without regard to the IPO quality. On the other side, investors who are well informed of the quality of the IPO bid only on the offerings that they think will give them superior returns. In case of weak initial public offering, the investors without information (uninformed investors) bid and consequently lose their investment or incur losses. The loss of their money is such big that the uninformed investors retreat to eventually leave the IPO market. This problem is known as the lemon theory in economics. It revolves around uncertainty of information about pricing of The IPOs. Opportunistically, Cohen & Dean (2005) suggest that underwriters needs and wants the investors without information to bid for the IPOs because informed investors are not many and they are sufficient in number. The underwriters solve this menace by reprising the IPOs so that to bring the uninformed investors bid. This phenomenon results in IPO under pricing. On the other hand, when investment banks allocate more shares (greater measure) to investors with information, IPO under pricing is reduced because the compensation that is needed to draw investors without information is greatly lower. Additionally, short run IPO under pricing is found to be lower when information concerning the IPO issuer is more readily available so that investors without information are at less of an advantage Aggarwal et al. (2002) adds that informational revelation is very much concerned in this theory for under pricing of IPO. It is informational based and it centers on the process of book building. In this case, the underwriter prepares a book of the potential investors together with the number of shares and their prices that they are willing to buy. The intention of this is to evaluate the demand and get information from the potential investors of the prices that they are willing to pay. The weakness of the issuer is another form of this theory. as Daily et al. (2003) points out, it suggest that short run IPO under pricing is connected to the weakness of the issuer, the under pricing is intended to compensate the purchase for this weakness. However, this form has weak evidential support. Conflicts in Investment Banking The theory of investment bank conflicts underpins that the investment banks posits and arranges for under pricing as a method of benefiting themselves together with some of their clients (Ritter, 2003). Nocera supports this theory with good evidence. Many of investment banks do respond to good and attractive incentives available in order to reduce IPO under pricing. A good example is given of higher commissions as they reduce IPO under pricing. Barber et al. (2007) notes that where American investors and an American investment bank are involved, IPO under pricing is reduced by more than 40 percent. This is attributable to the high underwriting costs or fees that the American investment banks charge. Furthermore, under pricing is reduced where the underwriters have a bigger stake in the initial public offer by way of ownership of the shares that are issued. Notably, Mehran & Stulz (2007) points out that the underwriters and investment banks who wrongly under price their own business lose the opportunity for future initial public offerings. Question 4 Existence of Short-Term IPO Under-Pricing in New Zealand The methodology used to examine the existence of short-term IPO under pricing in the New Zealand market is an event study approach (HSU et al. (2000). This applies market models and market adjusted returns to determine abnormal returns. The approach reveals and provides evidence of short term IPO under pricing performance in the New Zealand market. The study of this market is interesting, as many studies have focused more on the most established markets such as the US, Australia and the UK. The announcement year effects of the initial public offer are specified in the study. Among other events, the transition from private to public company is one of the most significant events for a firm. This is done by way of initial public offer. Henderson et al., (2006) observes that the purpose of going public by a firm is to raise funds, however, the benefits of going public bust be above the huge costs of setting the IPO. In this market, the costs of raising the funds by way of IPO should not be more than 8 percent of the funds to be raised though it depends with firm’s circumstances. The short-term performance of IPO under pricing has been a focus of attention in New Zealand. Of concern, firms report negative after market returns for initial public offer in New Zealand markets, the market has a negative after market returns. Importantly, firms enjoy first day returns of more than 18 percent. Short term IPO under pricing in this market has gone through wide observations. One notable observation is that regardless of the pricing method, the IPOs tend to yield considerable returns in the days straight away following the IPO. In their study, Mak & Roush (2000) found that more than 28 percent of IPOs in New Zealand market are under priced. The aftermarket is not efficient immediately for valuing securities that have been issued hence the presence of abnormal returns. The abnormal returns ensue to the IPO investors of temporary valuation in the early trading of the stocks. This underpins that IPOs are underpriced by investment banks in order to create impression and appearance of excess demand. The short-term IPO under pricing in New Zealand market is closely related to the size of the discretionally accruals in the fiscal year that the IPO is issued. Existence of Short-Term IPO Under-Pricing in China As Chen et al., (2004) suggest, the stock market in china is an emerging market and it highly influenced by government regulations. Short run IPO under pricing is extensively documented in the Chinese market. Market adjusted returns are used to provide evidence of short run IPO under pricing in the Chinese market. There is major under pricing of IPOs in Chinese market and it is considerably related to numerous issuer associated possession individuality as well as pessimistically with the independent director numbers together with supervisions in the board. There are positive returns (initial) in the Chinese market. Sherman (2005) relates this to the presence of economically and statistically important first day under pricing of IPOs. The volume of the IPOs and the first day returns are highly auto correlated and that most firms issues their shares to the public when there is period with high initial returns (Dimovski & Brook, 2004). The short term IPO under pricing in china is attributed to variation of information between the issuers and the underwriters. The underwriters possess superior information and this contributes to significant first day returns. The underwriters have superior information about IPO demand whereas the issuers are incapable of discerning the allocation efforts of the underwriters. The offering firms therefore offer their stocks at a discount because some groups of investors hold more information to the issuer. This is done to guarantee investors with information purchase of the issue. The under pricing is further expected to increase due to monotonic relationship that exist between investor uncertainty and expected IPO under pricing regarding the value of the IPO. References Aggarwal, R. K., Krigman, L., & Womack, K. L. 2002. Strategic IPO under pricing, information momentum, and lockup expiration selling. Journal of Financial Economics, 66(1), 105-137. Barber, B. M., Lehavy, R., & Trueman, B. 2007. Comparing the stock recommendation performance of investment banks and independent research firms. Journal of Financial Economics, 85(2), 490-517. Bayley, L., Lee, P. J., & Walter, T. S. 2006. 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Appendix ASX Code Company Name Issue price last trading price Difference Initial return AAJ Aruma Resources Limited 0.2 0.19 -0.01 -5 ABZ Australian Bauxite Limited 0.2 0.255 0.055 27.5 AFV Aurora Funds Limited 2 2 0 0 AIR Astivita Limited 0.5 0.771 0.271 54.2 AKA Australia Minerals and Mining Group Ltd 0.2 0.206 0.006 3 ALA Applabs Technologies Ltd 0.25 0.275 0.025 10 ANW Aus Tin Mining Ltd 0.2 0.18 -0.02 -10 AQF Australian Governance Masters Index Fund Limited 1.6 1.62 0.02 1.25 AQQ Aphrodite Gold Limited 0.2 0.2 0 0 AUC AusGold Limited 0.2 0.181 -0.019 -9.5 AVY Avenue Resources Limited 0.2 0.22 0.02 10 BEZ Besra Gold Inc 0.26 0.23 -0.03 -11.53846154 CAY Canyon Resources Ltd 0.2 0.221 0.021 10.5 CGR Careers Multilist Limited 0.2 0.21 0.01 5 CNL Celamin Holdings NL 0.2 0.165 -0.035 -17.5 CPD Condoto Platinum NL 0.2 0.22 0.02 10 DAU Dampier Gold Limited 0.5 0.56 0.06 12 DLX DuluxGroup Limited 2.65 2.54 -0.11 -4.150943396 DRM Doray Minerals Limited 0.2 0.192 -0.008 -4 DTE Dart Energy Limited 0.75 0.738 -0.012 -1.6 DUO Dourado Resources Limited 0.2 0.195 -0.005 -2.5 ELT Elementos Limited 0.25 0.204 -0.046 -18.4 EMX Energia Minerals Limited 0.2 0.208 0.008 4 EQU Equator Resources Ltd 0.2 0.172 -0.028 -14 GCY Gascoyne Resources Limited 0.2 0.185 -0.015 -7.5 GMM General Mining Corporation Limited 0.2 0.159 -0.041 -20.5 GRG GRG International LTD 0.2 0.24 0.04 20 GUF Guildford Coal Limited 0.2 0.18 -0.02 -10 HCH Hot Chilli Limited 0.2 0.21 0.01 5 HOR Horseshoe Metals Limited 0.2 0.26 0.06 30 IFZ Infratil Limited 1.28 1.28 0 0 ISH Ishine International Resources Limited 0.2 0.2 0 0 IVX Invion Limited 1 0.361 -0.639 -63.9 JKA Jacka Resources Limited 0.2 0.177 -0.023 -11.5 KBL KBL Mining Limited 0.2 0.174 -0.026 -13 KMD Kathmandu Holdings Limited 1.9 1.76 -0.14 -7.368421053 KNL Kibaran Resources Limited 0.2 KRA Killara Resources Limited 0.2 Mean -0.819661833 LGM Luiri Gold Limited 0.2 Median -0.8 LRS Latin Resources Limited 0.2 Maximum 54.2 LSN Lawson Gold Limited 0.2 Minimum -63.9 Read More