Ipos And Underpricing

Determining the correct offering price is the most difficult thing an underwriter must do for an initial public offering. The issuing firm faces a potential cost if the offering price is set too high or too low. If the issue is priced too high, it may be unsuccessful and have to be withdrawn. If the issue is priced below the true market value, the issuer's existing shareholders will experience an opportunity loss when they sell their shares for less than they are worth.

Underpricing is fairly common. It obviously helps new shareholders earn a higher return on the shares they buy. However, the existing shareholders of the issuing firm are not helped by underpricing. To them, it is an indirect cost of issuing new securities. For example, on April 5, 2000, Krispy Kreme, maker of delicious doughnuts, went public, selling 3 million shares at a price of $21, thereby raising $63 million. While Krispy Kreme's business is full of holes, its stock was not. At the end of the first day of trading, the stock sold for $37 per share, up 76 percent on the day. Based on these numbers, Krispy Kreme's shares were apparently underpriced by $16 each, which means that the company missed out on an additional $48 million. That's a lot of doughnuts, but it pales in comparison to the money "left on the table" by companies such as eToys, whose 1999 8.2 million share IPO was underpriced by $57 per share, or almost a half a billion dollars in all! eToys could have used the money; it was bankrupt within two years.

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