Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy- Raising Capital © The McGraw−Hill^569
Companies, 2002
tale, Jones gets fewer shares when more knowledgeable investors swarm to buy an un-
derpriced issue and gets all he wants when the smart money avoids the issue.
This is an example of a “winner’s curse,” and it is thought to be another reason why
IPOs have such a large average return. When the average investor “wins” and gets the
entire allocation, it may be because those who knew better avoided the issue. The only
way underwriters can counteract the winner’s curse and attract the average investor is to
underprice new issues (on average) so that the average investor still makes a profit.
Another reason for underpricing is that the underpricing is a kind of insurance for the
investment banks. Conceivably, an investment bank could be sued successfully by an-
gry customers if it consistently overpriced securities. Underpricing guarantees that, at
least on average, customers will come out ahead.
A final reason for underpricing is that before the offer price is established, investment
banks talk to big institutional investors to gauge the level of interest in the stock and to
gather opinions about a suitable price. Underpricing is a way that the bank can reward
these investors for truthfully revealing what they think the stock is worth and the num-
ber of shares they would like to buy.
NEW EQUITY SALES AND THE VALUE
O FTHE FIRMWe now turn to a consideration of seasoned offerings, which, as we discussed earlier,
are offerings by firms that already have outstanding securities. It seems reasonable to
believe that new long-term financing is arranged by firms after positive net present
value projects are put together. As a consequence, when the announcement of external
financing is made, the firm’s market value should go up. Interestingly, this is not what
happens. Stock prices tend to decline following the announcement of a new equity is-
sue, although they tend to not change much following a debt announcement. A number
of researchers have studied this issue. Plausible reasons for this strange result include
the following:
- Managerial information. If management has superior information about the market
value of the firm, it may know when the firm is overvalued. If it does, it will
attempt to issue new shares of stock when the market value exceeds the correct
value. This will benefit existing shareholders. However, the potential new
shareholders are not stupid, and they will anticipate this superior information and
discount it in lower market prices at the new-issue date. - Debt usage. A company’s issuing new equity may reveal that the company has too
much debt or too little liquidity. One version of this argument says that the equity
issue is a bad signal to the market. After all, if the new projects are favorable ones,
why should the firm let new shareholders in on them? It could just issue debt and
let the existing shareholders have all the gain.
CONCEPT QUESTIONS
16.5a Why is underpricing a cost to the issuing firm?
16.5bSuppose a stockbroker calls you up out of the blue and offers to sell you “all
the shares you want” of a new issue. Do you think the issue will be more or less
underpriced than average?CHAPTER 16 Raising Capital 541