The Pricing of Initial Public Offerings when IPO Size and Investment Choice are Endogenous

Abstract

This paper shows that the underpricing of a one-shot equity offering can be explained as a direct result of personal wealth maximization by the original shareholders. When a firm is taken public to raise capital for investment the original shareholders have to trade-off how much capital to raise and invest against how much fractional firm ownership to retain. Asymmetric information therefore creates a dilemma for the capital constrained owners of a firm with above-average investment opportunities. On one hand, their higher return on investment translates into a greater marginal gain from raising and investing more capital than for the owners of a lower quality firm. On the other hand, their firm's value is increasing more rapidly with investment than the value of a lower quality firm. This makes raising additional outside equity capital increasingly costly. The inherent relationship between the returns on investment and the firm values results in a violation of the single-crossing property. An investment policy exists that optimally trades-off an above-average firm's higher marginal costs of outside equity against its greater marginal losses from foregoing investment. At this investment policy issuing underpriced equity is shown to dominate all possible further changes in the investment policy. Several new empirical implications are derived.