Question

Explain why, when underwriting new security offerings, investment bankers prefer that the securities be underpriced. Identify and explain the different cost associate with an IPO How is it computed?

Answer 1

In an Initial public offering (IPO); a private company first time offers its shares to the public through an investment banker which works as an underwriter for securities. Company and its investment banker decide the price and the number of shares that will be offered in the IPO by estimating the expected future cash flows of the company/project and its fund requirements.

While underwriting new security offerings, investment bankers prefer that the securities should be underpriced to encourage the participation of institutional investors. The retail investors also get a signal about stock's market value through the institutional investor’s participation in IPO so they also participate at higher level. Underpricing reduces the underwriting risk for the investment bankers in a firm commitment underwriting. Where underwriters agree to buy the securities from the corporation and resell them to other security dealers.

The different costs associates with an IPO are underwriting spread, out of pocket expenses and underpricing cost.

• Underwriting spread is calculated by the total amount received by issuer and the total amount of issue.
• Out of pocket expenses are legal fees, accounting expenses, printing cost, SEC filing fees, travel cost or any other expenses mentioned in its prospectus.
• And underpricing cost is an opportunity cost which is calculated as the difference between closing price of the security on the day of its first listing on stock exchange and its issue price in an IPO.