Question

What do underwriters do? Why is underpricing a cost to the issuing firm? Why should a financial manager be concerned about underpricing?

In the aggregate, debt offerings are much more common than equity offerings and typically much larger as well. Why? Why are the costs of selling equity so much larger than the costs of selling debt?

Answer 1

Role of underwriters

1. Assess the risk involved in placement of securities and assumes those risks on behalf of the issuer.

2. Ensures that the issue of a security is fully subscribed by appropriately pricing the same and guarantees the issuer to subscribe to the securities which were not subscribed by the public or the anticipated investors.

3. Many a times, underwriters also lend credibility to the issue through their association with the issuer.

Underwriting is a cost to the issuing firm since it lowers the net proceeds received by the firm, depending on the commission or fees charged.

Under-pricing is a typical concern for the issue of securities since most of the securities laws prescribes a minimum public subscription for the issue to be successful. If the same doesn't happen, the regulators may require the company to either withdraw the issue or refund the application money, as applicable. Under-subscription may also tarnish the brand name of the issuer

Debt offerings are much more common that equity due to the following reasons:

1. Debt is cheaper than equity. Since debt has a liquidation and payment preference with regard to both interest and principal, it is safer than equity. Hence, investors are willing to assume debt for lower cost to the issuer.

2. Debt is also safe since the same has some security or collaterals attached.

3. There are also various covenants in-built into a debt agreement that restricts a company to take excessive risk beyond what was stipulated, restrict the company to use the proceeds for the purpose for which it was raised and have in-built triggers (like interest coverage ratios, DSCR etc. ) that may enable a debt holder to take some action or remedy.

4. Governments is also a large participant and issuer in the bond markets across the world as they raise funds for various objectives including infrastructure etc.

Due to the same reasons as mentioned above, equity is more expensive than debt