FIN 260 Lecture Notes - Lecture 62: Underwriting, Shortage
• Cont’d Theories of Underpricing:
1. The Lawsuit Avoidance Hypothesis:
➢ All participants in the offer who sign prospectus are liable for any
material omissions.
o One way of reducing frequency & severity of future lawsuits is to
underprice.
o Underpricing IPO seems to be a very costly way of reducing
probability of future lawsuit.
o Furthermore, other countries in which securities class actions are
unknown, such as Finland, have just as much underpricing as in the
U.S.
2. Ownership Dispersion Hypothesis:
➢ Issuing firms may intentionally underprice shares in order to generate
excess demand & be able to have a large number of small shareholders.
➢ Disperse ownership will both increase liquidity of market for stock, &
make it more difficult for outsiders to challenge management.
o It’s a very heavy cost to do this.
• EX of IPO Costs Going Public:
➢ When Microsoft became public in 1986, the situation was the following:
o Underwriters acquired a total of 2.8 million shares for $19.69 each & sold
them to the public at an offering price of $21.
o The difference (spread of $1.31) is the amount the underwriter is making.
➢ Due to underpricing, within hours of the stock hitting the secondary market,
price went to $35.
o For Microsoft the expenses of going public was:
1. Underwriting Spread:
$2.8 million * $1.31 = $3.7 million
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