Corporate Finance Examples and Topics
Initial Public Offering
IPO is one of the basic strategy used by a large corporation in the capital market. The initial public offering is the offering of the stocks of the company to the general public through the stock exchange. The initial offering could be made by the new company, young or the old company which tries to raise its capital through listing on the stock exchange and go for a public offering of its shares. The large scale organisations always need huge capital in a short time. The potential investors of these stocks are large corporations, financial institutions, and other wealthy firms. These investors aim to acquire new organisations and utilise their idol capital to get maximum return. The existing shareholders of the company withdraw entirely or some part of their shares, and offer these publically for sale without raising any fresh capital. The shares are provided with the help of investment banks by the company called an issuer. The shares after the IPO are traded in the open market which is further sold by the investors with different prices set by the stock exchange through secondary market trading (The Economist Times, 2019, n.p). The reason for the IPO is to raise the additional capital to create a trading market of the firm for its stocks. After offering shares to the public for the first time with a specific par value of the stock, its value is influenced by various factors. The share price is purchased either with a higher rate than its par value, or more than the par value. The demand for the shares decides its pricing the stock market. When the value of the share is lower than its face value, it is called as underpricing. Sometimes the shares of the company undergo with underpricing, their IPO, referred to as the lower price than the market value (Loughran and McDonald, 2013, p.309). Here we will discuss the IPOs of two renowned companies of the United Kingdom, which decided to raise their capital through the public offering. First is Aston Martin the manufacturer of luxury cars, and sports cars. Its initial offering had disappointed the company management during the year 2018, and its share price was below than its market value. Though the company highly profitable, and well known throughout the country. Aston Martins IPO was underpricing, and its market price was 19 Pound however it sold at 17 Pounds initially. Second is the Mind Gym, which floated its shares publically during the mid of 2018 through the London Stock Exchange. Its debut was pleasant, and the company offered its shares with a market value of 146 pence. However, the demand was higher than its initial offer. The company had grabbed the attention of investors and its shares sold at 154 pence at the end of the fiscal year 2018. The company had raised more than 19 million pounds.
Underpricing of IPO
When the company has a lower price than the initial public offer of its shares. It is the most prominent attribute of IPO, which portrays the significant entry into the stock market. The initial return and the capital raised on the very first day of the stock trading at the stock market is substantial. It portrays the positive image of the company in the stock market. In several cases, organisations face abnormality in the share prices and demands which usually results in underpricing (Beatty and Ritter, 1986, p.216). The underpricing phenomena create potential problems for companies, both in monetary terms and non monetary terms. In this case, the Mind Gym was safe from the losses and consequences of underpricing. The company was enjoying an extra return on the initially offered price of its stocks.
On the other hand, Aston Martin was disappointed with its initial offering and has lost a considerable amount with respect to its expected returns. The underpricing can damage the image of the company in the external market. The reasons for underpricing could be either the initial offering might be higher, or the company had raised more capital. The initial offering needs proper market analysis and rational decisions by the finance department and the top management team of the organisation. It results in the wastage of the capital in such a way that the deficit amount is recorded as an expense (Bouzouita et al., 2015, p.787). It is an addition to the list of expenditures of the company. There are many theories which discussed the causes and its effects on the organisation in both the short run and long run. Here we will address some of these theories to highlight the reasons for underpricing of initial public offerings of the listed companies.
The initial public offering is a complex process that requires a lot of technicalities and procedures, so the companies do it through underwriters. There are no legal obligations to do it through the underwriter, and the company can go through itself as well without the services of the underwriting firms. Underwriters have expertise in the trade of shares in the stock market. They provide services to different companies, and they help the company to maintain the prices. To avail, the functions of underwriters are in the best interest of the company to cash their services (Binay et al., 2007, p.787). The value that is brought up the underwriting firm usually guarantees that the initial public offering will be accurately managed and efficiently marketed, and will provide support both before and after the public offering. The agreement with underwriter mainly composed of two basic conditions firstly commitment of the firm, and secondly its best efforts to succeed the company shares, and assist it in raising its capital. Underwriters are the investment banks which initially acquire all the stocks of the company and then sell it to the potential investors through properly marketing to the public (Dougal et al., 2012, p.641). Underwriter convinces the investors to purchase its shares with possibly higher prices. The benefit for the investment banks is the spread between the public offering price and the purchase price.
Aston Martin is an old company with successful growth and profitability during its history. The company is manufacturing both sports cars and luxury cars and having a better brand image in the market. The company is profitable and has a better financial position. The debut of Aston Martin in the stock trading market was not impressive, as its top management team was expecting. The companys opening price for its stock was a bit higher than the price demanded by the investors. The company stocks par value was of 19 Pounds while it has been sold 17 pounds which has a huge difference between the facts and our perceptions. The company sold its 25 per cent of shares in the initial offering, and the offer was open to the staff of the company, large institutional investors, and the members of owners club of Aston Martin. Moreover, private investors were also eligible to purchase the stock of the company.
As the firm is has earned a good brand name in the market, and the investors are well informed regarding the profitability of the firm. Aston Martin is continuously earning higher profitability since the last few years. However, the company share prices sold at the rate lower than its par value. The top management team of the company expected that it would earn 5 billion Pounds from its initial public offering. However, the amount that the company collected through its IPO was underpriced and raised only 4 billion from its stock traded in the market. Though the company has shown a positive gesture to the public, the company declared that our focus not on the short term gain or loss, but the company aims to develop a proper long term plan for the entry in the stock market. The company related the low demand of the stocks at its initial public offerings with the political situation of the country such as the decision of Brexit. The company has floated its shares for the first time on the London Stock Exchange (LSE) in October 2018 (Ft.com, 2019). The company has planned to raise its capital up to 5 billion Pounds from its initial offering. However, the entry of the company didnt meet the expectations of the company top management. It summed up with a diminished share price from 19 pounds to 17 pounds, which reduced its target range. Initial offering always equal to 25 per cent of its whole capital. Being at the top end of its range after setting an IPO price of the company was fallen and reduced the capital from 5.07 billion GBP to 4.02 billion GBP.
Mind Gym is the behavioural science firm, The share price of the company had the par value of 146 pence per share when it was floated on for the first time in the London Stock Exchange. While its market value was recorded as 154 pence by the end of 2018. The IPO of the company was lower than the actual sales price of the share. This difference was positive, and it was due to the high demand for the companys stock in the stock market. The company has raised its fund to GBP 145 billion in its IPO. The revenue of Mind Gym raised to 13 per cent, from 17.1 million to 19.4 million during the year 2018. The company is working in different regions and being profitable in all these countries. The companys revenue grew up to 13 per cent in the USA and Europe (MorningstarUK, 2018). The share price of the Mind Gym was 146 pence per share during the time it was floated for the first time in the London Stock Exchange. However, it grabbed the attention of investors, and they took interest to purchase it at a higher price. So its market value raised and its value increased, which was recorded as 154 pence by the end of 2018.
Theories of Underpricing IPOs
There are several theories proposed by the researchers which explained the phenomenon of underpricing of the initial public offering of stocks at the stock market. These theories deeply insight into the interests of the issuer, underwriters, and investors. Here we will discuss some essential theories regarding the underpricing of IPOs.
This theory describes the imbalance between the parties before making a specific agreement due to the failure of information shared, and the lack of knowledge of the issue. Here the term imbalance means that one party has more information about the market and the situations which helps that party to enjoy an advantage over the other party (Bajo et al., 2017, p.141). This theory states that it is not easy to collect all the relevant information, it is a complicated procedure which needs a lot of struggles. All the organisations struggle to get the desired outcomes from the market for its growth and sustainability. Due to the proper knowledge and information, the workers could produce better results for the organisation. This theory helps to identify different classes of investors and their approaches.
Moreover, it also keeps in consideration the role of issuers, underwriters, the investors, and provide clear information to avoid any dispute and mismanagement (Beck, 2017, p.42). If the information is limited or not reliable so the company has the risk regarding future growth, and it also affects the sale of its shares during initial offerings. Gathering proper information regarding the company financial position, and the future demand in the stock market is not only a complicated process but also an expensive procedure. Mostly the lake of information leads the investors to incur losses in the investment in stock. Similarly, information about the stock market, economic condition, and the trend of the stock exchange are essential for the company who is going for IPO. If a company comes up with a lower price of its stock it also has a negative impact on its sales, however, the higher price of the stock is also not affordable for investors.
In both cases, the difference between the market price and the par value of the share the knowledge of the stock market and all its relevant factors is inevitable. The underpricing indicates some problems in the information collection.
This theory explains the condition when one party takes advantage over other parties through the unique set of information that the party possesses. The success of a party is all based on the information and accurate decisions based on this information. According to this approach, one party conveys information about itself to other parties in the form of signals. It is used as a solution to avoid any market failure and losses. This theory explains the reasons of underpricing of the initial public offering of stock at the stock exchange (Obrimah, 2018, n.p). One of the most significant problems which sellers face in the market is trying to convince buyers that what they are selling is as good as they are claiming. The question usually arises when the buyer can not easily observe the features of the product. The degree of IPO low pricing is described with the help of the signalling theory (Ahmad et al., 2015, p.154). The signalling model was desined by Welch (1989 p. 432) in which he discussed that a well-informed issuer could use the initial underpricing offerings to signal their quality to their potential investors. They can recover their underpricing by the seasoned equity offering strongly at more favourable terms. This model also predicts the underpricing IPO of the firm are more likely to make an SEO, which makes the seasoned equity offering sooner after its initial public offerings (Park and Patel, 2015, p.798). This theory also helps the firm to determine the problems of underpricing. The company itself or through its agents convince its investors and to provide useful information regarding its performance, revenue, and profitability (Willenborg, 2015, p.1121). In the case of Aston Marting, the company was facing the problem regarding communication with the public. As the company has strong financial outcomes, however, these outcomes were not adequately communicated (Chahine et al, 2015, p.180).
Large organisations require a tremendous amount of capital for its broad level of operations immediately. So initial public offering is the best option for raising capital for such organisations. The IPO is affected by various factors such as the growth, profitability, and the management of the company. In some cases the initial offering is less than the expected outcomes, even the company has a good image in public (Carey et al., 2016, p.21). The underpricing of IPO in the stock market causes certain problems for the company in the stock market. For instance, Aston Martin is a profitable company with a strong financial history. However, its initial offering in 2018 in the stock market was quite disappointed. While the Mind Gym had a significant debut in the London Stock Exchange during the same fiscal year. The initial public offering of Mind Gym was more significant than the par value of its shares. Even both the companies had a strong financial background. Hence the IPOs of both the companies were affected by the information sharing and communication with its potential investors.
Ahmad, K., Han, J., Hutson, E., Kearney, C., and S. Liu 2015, Mediaexpressed negative tone and firm-level stock returns. Journal of Corporate Finance, 37, 152172.
Bajo, E. and Raimondo, C., 2017. Media sentiment and IPO underpricing.Journal of Corporate Finance,46, pp.139-153.
Beatty, R.P. and Ritter, J.R., 1986. Investment banking, reputation, and the underpricing of initial public offerings.Journal of financial economics,15(1-2), pp.213-232.
Beck, J., 2017. Determinants of IPO Underpricing Tech vs Non-Tech Industries.Major Themes in Economics,19(1), pp.39-55.
Binay, M.M., Gatchev, V.A. and Pirinsky, C.A., 2007. The role of underwriter-investor relationships in the IPO process.Journal of Financial and Quantitative Analysis,42(3), pp.785-809.
Bouzouita, N., Gajewski, J.F. and Gresse, C., 2015. Liquidity benefits from IPO underpricing ownership dispersion or information effect.Financial Management,44(4), pp.785-810.
Carey, P., Fang, V. and Zhang, H.F., 2016. The role of optimistic news stories in IPO pricing.Journal of International Financial Markets, Institutions and Money,41, pp.16-29.
Chahine, S., Mansi, S., and M. Mazboudi 2015, Media news and earnings management prior to equity offerings. Journal of Corporate Finance, 35, 177195.
Dougal, C., Engelberg, J., Garcia, D. and Parsons, C.A., 2012. Journalists and the stock market.The Review of Financial Studies,25(3), pp.639-679.
Ft.com. (2019).Aston Martin cuts maximum share price for IPO Financial Times. online Available at https//www.ft.com/content/2226ed32-c542-11e8-bc21-54264d1c4647 Accessed 7 Feb. 2019.
Loughran, T. and McDonald, B., 2013. IPO first-day returns, offer price revisions, volatility, and form S-1 language.Journal of Financial Economics,109(2), pp.307-326.
MorningstarUK. (2018).Mind Gym Says Revenue Rises On New Clients But Profit Hit By IPO Costs. online Available at http//www.morningstar.co.uk/uk/news/AN_1543925667055627200/mind-gym-says-revenue-rises-on-new-clients-but-profit-hit-by-ipo-costs.aspx Accessed 7 Feb. 2019
Obrimah, O.A., 2018. IPO Signaling Theory A Revisit.
Park, H.D. and Patel, P.C., 2015. How does ambiguity influence IPO underpricing The role of the signalling environment.Journal of Management Studies,52(6), pp.796-818.
The Economic Times. (2019).Ipo - What is Ipo Ipo meaning, Ipo definition - The Economic Times. online Available at https//economictimes.indiatimes.com/definition/ipo Accessed 6 Feb. 2019.
Welch I (1989) Seasoned offerings, imitation costs and the underpricing of initial public offerings. Journal of Finance, 44 421-450
Willenborg, M., Wu, B. and Yang, Y. S. (2015) Issuer operating performance and IPO price formation Journal of Accounting Research 53, 1109-1149
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Subject: Corporate Finance
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