Pricing Initial Public Offering

If the price of an initial public offering (IPO) is too low then the issuer losses the ability to raise the intended capital. The issuer would like to take advantage of this opportunity to raise capital, but with lower price the investor would take advantage of this low price and resell it for a marginal profit (Smith, 2001). The issuer would only receive capital from the IPO but the marginal profit from under pricing would be lost (or gained by the investor). Investors, especially the informed ones, would not bid for an overpriced IPO simply because they do not profit from it, at least in the near future. As a result the issuer will not raise the intended capital. The best way to set a price for an IPO is to use the services of an underwriter, where the underwriter has the market information and skill to estimate an attractive price for the IPO (Ibbotson & Sindelar, 2001). Experienced underwriter would have a good reputation for setting the right (underpriced) IPO to attract enough investors to raise the intended capital and benefit the investors with marginal profit.

References

Ibbotson, R., & Sindelar, J. (2001). Initial Public Offerings. In The new corporate finance: where theory meets practice (pp. 309-317). New York: McGraw-Hill Irwin.

Smith, C. (2001). Raising capital: theory and evidence. In The new corporate finance: where theory meets practice (pp. 277-293). New York: McGraw-Hill Irwin.