Signalling and the Pricing of New Issues

Abstract

A puzzling phenomenon in finance is the underpricing of new issues of common stock. A signaling model, with two signals, two attributes, and a continuum of signal levels and attribute types, is developed to explain this underpricing. The model has two signals: (1) the fraction of the new issue retained by the issuer, and (2) its offering price. These convey to the investors the unobservable intrinsic value of the firm and the variance of its cash flows. In the model, an issuer has better information about future cash flows than outside investors; to overcome the asymmetric information problem, the issuer signals the firm's value by offering discounted shares and retaining some of the new shares. The model is consistent with the rationale for underpricing given by many investment professionals. The model's signaling schedule (a function of project variance and issuer's fractional holdings) reveals that the intrinsic value of the firm is positively related to the underpricing of the new issue; there is a positive relation between project variance and underpricing discount; there is a negative relation between the fractional holdings and the project variance; that fractional holdings and underpricing discount are positively related; that fractional holdings and firm value are positively related; and that firm's value and variance are positively related. Three empirical predictions and eight testable implications are articulated. Existing empirical evidence on new issues is consistent with the model's implications. Two applications are suggested: where high firm value is signaled through (1) expensive investment bankers, auditors, and advertising, and (2) high dividends. (TNM)