A Tax-based Motive for the Underpricing of IPO

A Tax-Based Motive for the Underpricing of Initial Public Offerings

Mary Ann Reside; Richard M. Robinson; Arun J. Prakash; Krishnan Dandapani

Managerial and Decision Economics, Vol. 15, No. 6. (Nov. - Dec., 1994), pp. 553-561.

Stable URL:http://links.jstor.org/sici?sici=0143-6570%28199411%2F12%2915%3A6%3C553%3AATMFTU%3E2.0.CO%3B2-L

Managerial and Decision Economics is currently published by John Wiley & Sons.

Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available athttp://www.jstor.org/about/terms.html. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtainedprior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content inthe JSTOR archive only for your personal, non-commercial use.

Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained athttp://www.jstor.org/journals/jwiley.html.Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printedpage of such transmission.

The JSTOR Archive is a trusted digital repository providing for long-term preservation and access to leading academicjournals and scholarly literature from around the world. The Archive is supported by libraries, scholarly societies, publishers,and foundations. It is an initiative of JSTOR, a not-for-profit organization with a mission to help the scholarly community takeadvantage of advances in technology. For more information regarding JSTOR, please contact [email protected].

http://www.jstor.orgSat Sep 15 00:50:36 2007

MANAGERIAL AND DECISION ECONOMICS, VOL. 15,553-561 (1994)

A Tax-Based Motive For The

Underpricing Of Initial

Public

Offerings

Mary Ann Reside and Richard M. Robinson Eastern Kentucky Uniwrsity, Richmond, KI: USA

Arun J. Prakash and Krishnan Dandapani Florida International Uniwrsity, Miami, FL, USA

This paper presents a model of entrepreneurial wealth maximization for the pricing of initial public offerings (IPOs). It is an extension of one previously presented in the literature. The model shows that personal tax rates on ordinary income and capital gains may, in part, determine IPO pricing: an increase in the capital gains tax rate should lower the degree of underpricing. An empirical analysis of the effect of the Tax Reform Act of 1986, which raised the capital gains tax rate, shows that the average degree of underpricing did decrease as predicted, and that this occurs after controlling for other possible influences.

of IPO pricing is reviewed and a considerableINTRODUCTION extension of the model is presented. Whereas the DDPR model shows the influence of tax rates on

Numerous studies have documented significant the proportion of IPOs underpriced, the exten- underpricing of IPOs. In a recent article in this sion to the model presented here illustrates the journal, Dandapani et al. (1992, hereinafter influence of tax rates on the degree of underpric- DDRP) provide yet another explanation, based ing of each IPO issue. In addition, an expanded on personal taxes, for the underpricing of inital empirical analysis is presented in this paper as public offerings (IPOs). The 'traditional' hypothe- compared to DDPR. This new empirical analysis ses for the underpricing phenomenon include involves a much-expanded data set, and also more risk-averse underwriter/risk compensation, extensive parametric and nonparametric analysis monopsony power, agency cost, institutional lag, of the tax effects on IPO underpricing. speculative bubble, implicit insurance and asym- metric information. See DDPR for a review of these hypotheses. THEORETICAL FOUNDATION

Adding to these traditional hypotheses, DDPR propose a model by which underpricing is dependent on the entrepreneur's (1) personal tax rate The Tax-based IPO Model of DDPR on ordinary income (and, concomitantly, the ap- The DDPR tax-based model assumes that the plicable capital gains tax rate), (2) ability to defer purpose of the IPO is to fund a project with capital gains, and (3) the proportion of retained positive net present value. To simplify the analy- ownership in the firm. They present a theoretical sis, agency problems between the issuers and the argument that there is a tax-based motive for IPO underwriters, and informational asymmetries issuers to underprice. between the issuers and the market, or between

This paper extends the theoretical argument for groups of investors, are assumed nonexistent. a tax-based motive for IPO underpricing. The Furthermore, the entrepreneur is assumed re-DDPR entrepreneurial wealth-maximizing model sponsible for setting the issue price of the shares.

CCC 0143-6570/94/060553-09

O 1994 by John Wiley & Sons, Ltd.

554 M. A. RESIDE, R. M. ROBINSON, A. J. PRAKASH AND K. DANDAPANI

While correct pricing would allow full realization of the project's net present value, it may also force the net present value to be received as a currently realized taxable gain. Underpricing the issue, which could result in a currently unrealized capital gain, may therefore be in the best inter- ests of the entrepreneur since the tax would be deferred until the gain is realized. The en-trepreneur faces the problem of pricing the IPO so that he or she receives the maximum current wealth from the new project. The entrepreneur may appropriate the wealth

generated by the project by paying himself a dividend (equal to the net present value of the project) prior to the issue, while borrowing against the future value of the project in order to finance the dividend. Alternatively, the entrepreneur can charge the firm a royalty equal to the net present value and payable from the proceeds of the issue. Assuming that there is agreement between the market and the issuers on the value of the issue, then post-issue, the market will price the firm at its present value and it will be indifferent towards the method that the entrepreneur might choose for appropriating this 'surplus' net present value. Each of the above methods, however, whether a prior dividend or a royalty schedule, imposes a tax liability on the entrepreneur. In addition, for the case of the entrepreneur who retains a portion of the issue, he or she may receive part of his investment back as realized taxable gains. The entrepreneur's decision on the issue price

will therefore affect his or her return in two ways, given that the IPO issue price is set below the project's present value, and therefore below the market value. The first way is that a higher IPO price increases 'entrepreneurial surplus' to be appropriated by either a dividend or royalty. This 'surplus' is the difference between the project's cost and the IPO price. The second way is that if some proportion of ownership is retained by the entrepreneur through the purchase of shares of the IPO at the offer price, then a lower issue price increases the capital gain to his or her shares. This capital gain occurs when the share price rises in the after-market to reflect the present value of the funded project. In a world with personal taxes, the en-

trepreneurial surplus will be taxed at rates applicable to ordinary income. Capital gains will be taxed when realized, and at rates applicable to capital gains income, which prior to 1987 were

typically lower than ordinary income tax rates. The theoretical analysis that follows remains valid, however, for the current tax laws, where the ordinary income tax rate equals the capital gains tax rate, due to deferral capability. The former can lead the entrepreneur to set the issue price below the present value of the project so as to receive returns in the form of capital gains rather than as surplus. The choice of the issue price is modeled below. Let:

PV = present value of the proposed project; C = current period cash outflow needed to fi-

nance the project; P = total issue price chosen by the entrepreneur

(C IP IPV); a =proportion of firm retained by the en-

trepreneur (0 I a < 1); To = entrepreneur's personal tax rate on ordi-

nary income; Tk = entrepreneur's tax rate on capital gains in-

come (Tk < To); and y = a present-value interest factor to measure

the present value of deferred tax on realized capital gains (0 < y < I), over the entrepreneur's desired deferral period, where if y = 1, capital gains cannot be deferred and must be realized in the current period, and if y = 0, indefinite deferral would be possible and the capital gains tax could be completely avoided.

The entrepreneur wishes to maximize his or her wealth, W, which consists of the entrepreneurial surplus taxed at To, shown as ( P -C) (1 - To) in Eqn. (1) below, plus the capital gains taxed at yTk, shown as (PV-P)a(1 - YT,). The en-trepreneur solves the maximization problem given by:

Max W= ( P - C)(1 -To) + (PV-P )a

This equation is similar to the DDPR linear model which, given a , results in comer solutions that indicate whether or not underpricing exists, but does not indicate the degree of underpricing. The model presented in the next section, however, is nonlinear in that a is a function of P. This model results in solutions for the magnitude of underpricing.

555 UNDERPRICING OF IPOS

The Extended Tax-based IPO Model capital gains tax rate on the degree of underpric- In order to ascertain the degree of underpricing, assume that a , the proportion of entrepreneurial retention, is some unspecified function of P. That is, allow a to be influenced by the issue price, P, in that the lower the issue price, the higher the proportion of the issue retained. This would occur because the lower the issue price, the greater the future capital gain to be exploited and the more attractive the holdings of the issue would be. This relation is expressed by Eqn. (2), where f (P) is at least a twice-differentiable function of P. The maximization problem, therefore, reduces to that expressed by Eqn. (3):

a =f ( P ) (2) where f ' (PI < 0:

The first-order condition for an extremum is given by Eqn. (4), and the second-order condition for a maximum is given by inequality (5):

dW/dP= (1 - To)-f ( P ) ( l - yTk) +(PI / -P)f l ( l - yTk) = 0 (4)

d 2 w / d p 2 = -2fr(1 - yTk)+ (Pv-P)f" x (1 - yTk) < 0 (5)

If f ' < 0, as assumed above, then the second- order condition requires that f" < 0 provided that underpricing exists, i.e. PV> P. The first-order condition, however, reduces to:

PV- P = {a- (1 - To)/(l - yTk)}/fl (6) If f ' < 0, as assumed, then for underpricing to exist, the following must hold:

The Effects of Capital Gains Taxation on

Price

In the above analysis, the tax rates To and T, are assumed constant, or exogenous to the maximization model. Nonetheless, it is the purpose of this analysis to explain the impact of a change in the

ing. This must be accomplished by finding the impact of a change in this tax rate on the issue price while maintaining the conditions necessary for the wealth maximization. Analysis of the impact of changes in Tk on P, given that the first and second-order conditions for a maximum are maintained, is achievable by taking the total differential of the first-order condition, Eqn. (6). Setting this total differential to zero so that the first-order condition continues to be maintained allows analysis of the sign of dP/dTk. This total differential is given by Eqn. (8a), which reduces to Eqn. (8b). Using (8b), we obtain dP/dTk as given by Eqn. (9):

dP{-2f1(l - yTk)+ (PV-P)f"(l - YTk)} +dTky[a - (PV-P)f11 = O (8a)

d p / d ~ ,= -{ay- y ( p v - p ) f 1 } / ( ~ 2 ~ / ~ p 2 ) (9)

In order to analyze the sign of dP/dTk, note that d2w/dp2 < 0 by the second-order condition (5). Also, if y > 0, a > 0, and (PV -P ) > 0 so that underpricing exists, then since f ' < 0, it must be that dP/dTk > 0: an increase in the tax rate on capital gains increases the wealth-maximizing price of the IPO.

The wealth-maximizing IPO pricing model therefore indicates that an increase in the capital gains tax rate should cause the issue price to rise and the portion of the issue retained by the entrepreneur to decrease. The price rises because the capital gain is less attractive relative to the surplus-income component of wealth, and the proportion retained falls because of the de-creased attractiveness of the capital gain.

The Interest Rate Effect on Price In order to investigate the effects of a change in the discount rate (and therefore the present-value interest factor y) on IPO prices, the total differential of Eqn. (6) is set equal to zero. This allows changes in P and y to occur while maintaining the first-order condition for a maximum. This differential is presented in Eqn. (lOa), which together with Eqn. (5), reduces to Eqn. (lob).

556 M. A. RESIDE, R. M. ROBINSON, A. J. PRAKASH AND K. DANDAPANI

Equation (11) follows from (lob): dP{-2f1(l - yTk)+f"(PV-P)( l - yTk)}

+dy{Tk[a - ( Pv - P ) f']} = 0 ( 1 0 ~ ) d ~ ( d ~ w / d ~ ~ ) (PV- p)fl]} =+ d y { ~ ~ [ ( ~ - o

(lob)

Since PV >P for underpricing, and f ' < 0,a > 0 and d2w/dp2 < 0 by the second-order condition for a maximum it follows that dP/dy > 0. Assume y = (1 + i)-', where t is the en-

trepreneur's deferral period and i is his or her discount rate. Then dy/di = -t(l + i)-'- l, and since t > 0 it must be that dy/di < 0. Also, since d P/di = (d P/d y Xd y/di), and since d P/dy > 0, and dy/di < 0, then dP/di < 0. Thus, there is an inverse relationship between the issue price and the discount rate used: an increase in the discount rate that the entrepreneur uses to evaluate the present value of the tax deferral lowers the wealth-maximizing price of the IPO.

Summary of Theoretical Foundation A model of IPO underpricing, where the degree of underpricing is dependent upon the issuer's proportion of retained ownership, applicable tax rates on income and capital gains, and capital gains deferral capability, is presented above. Since the Tax Reform Act of 1986, capital gains have been taxed at the personal tax rate for tax years beginning after 1986. Analysis of the necessary conditions for tax-related underpricing reveals that if issuers base their pricing decisions, at least in part, on the tax treatment of surplus and/or subsequent capital gains from an IPO, then IPOs should be less underpriced subsequent to the tax reform, and as a result, the average degree of underpricing should be less. That is, in the presence of special lower capital gains tax rates, the degree of underpricing should be greater.

EMPIRICALANALYSIS

Empirical analyses of IPO underpricing generally study the initial excess returns; i.e. returns in excess of the market average rate of return. In

particular, the IPO return is measured from offer date to date of first trade in the secondary market, and the IPO return is adjusted by the return on the market index. This initial excess (market- adjusted) return for an IPO is defined in the same manner as McDonald and Fisher (1972), Block and Stanley (1980), Neuberger and LaChapelle (1983), and others. Although the model does not explicitly consider the risk of an individual stock issue, market effects on the returns of IPOs are taken into consideration as noted by McDonald and Fisher (1972) and Beatty and Ritter (1986).

The Data

Two basic, desirable features of the stocks included in the sample were identified prior to data collection. These are (1) that the issues be of initial, stock-only offerings, and (2) that the firms' offerings be of varied size. The latter requirement is necessary since there may be differing underpricing effects due to firm size. As Stoll and Curley (1970), Logue (1973), Bear and Curley (1973, Block and Stanley (1980) and Ritter (1984) hypothesized, size may influence the risk of the issue in that larger firms may be better known to the financial markets prior to the IPO, and may be less risky than smaller firms. OTC stocks are used in this study so that characteristics that are restricted by other stock exchanges, such as firm size, are not artificially limited. The first 'desirable characteristic' listed above is

also important. Common stocks issued in unit offerings or mixed debt-equity offerings were not included in the sample since the return process for them may reflect the behavior of the other financial instruments in the offering, and not of the common stock itself. Consequently, the data consist of OTC common stocks that were not offered with warrants or in mixed debt-equity offerings. The data examined for this paper consist of

1308 IPOs of firms 'added to the list' of Standard & Poor's OTC Daily Stock Quotations. First-trade prices were gathered from the same source as were levels of the 'OTC Industrial Index'. IPO offering prices were gathered from Moody's OTC Industrial Manuals. Firm characteristics such as the date of incorporation, pre-offer total assets, long-term debt, IPO issue size, underwriter, and the date of offer were gathered from the same


Moody's source. AAA and BBB monthly indexes of yields were gathered from the monthly Federal Reserve Bulletins, along with monthly observations on the CPI. The data span a ten-year period from January 1980 through December 1989.

Testing the Distribution of Excess Returns There is a striking absence in the IPO underpricing literature of tests of the specific distribution for excess returns. As noted by Block and Stanley (1980), however, market-adjusted returns may not be normally distributed. Student's t-test, therefore, may not be an appropriate test statistic for initial excess returns. Given that the mean initial excess return for

the entire sample is 15.97%, with a standard deviation of 44.51%, and that the median is 3.70%, the sample distribution of initial excess returns exhibits right-skewness; therefore the population may not be normally distributed. A chi-square goodness-of-fit test (see Freund, 1971, p.338; Johnston, 1972, p. 426; Anderson et al., 1981, p. 322) of the null hypothesis that the excess returns are normally distributed was performed. The computed X 2 measure for the sample was 1702.5. Since, at a 1% level of significance, for a sample size of 1308, the critical value for the X 2 is 1443.5, the null hypothesis of normality cannot be accepted at the 1% level of significance. The rejection of the normality hypothesis is

consistent with the finding of sample right-skewness. Nonparametric tests on shifts in the excess returns are appropriate since the null hypothesis of normally distributed excess returns was not accepted at the 99% confidence level. Risking redundancy, however, both parametric and nonparametric tests are presented below.

Testing the Tax Change Effect: Parametric

Tests

Prior to January 1987, capital gains on assets held for at least 6 months were taxed at rates lower than ordinary income tax rates. The Tax Reform Act of 1986 eliminated this practice and, for each individual investor, made capital gains taxable at the investor's ordinary income tax rate. For exam- ple, an asset purchased on the last day of June 1986 and sold for a gain on the last day of December 1986 would have been held for 6 months and would have qualified for preferential

capital gains tax treatment. If the asset had been purchased after the last day of June 1986, the holding period would not have been long enough to qualify for preferential capital gains tax treatment. If the asset had been sold after the last day of December 1986, the Tax Reform Act required the capital gain to be taxed at the investor's ordinary income tax rate. In order to test the effect of the Tax Reform

Act on excess returns of IPOs, the data set of 1308 returns was divided into the 1021 observations prior to and including the first six months of 1986 and the 287 observations subsequent to June 1986. The mean excess return for the first subperiod is 18.17%; the standard deviation is 49.36%. The mean excess return for the second subperiod is 8.11%; the standard deviation is 17.08%. The t-statistic for subperiod one is 11.76, with

1020 degrees of freedom. The t-statistic in the second subperiod is 8.03, with 286 degrees of freedom. Hence, the null hypothesis of no underpricing in either subperiod separately cannot be accepted at any reasonable confidence level. The tax-based model of underpricing suggests

that the mean excess return in subperiod one should be greater than the mean excess return in subperiod two. To test the null hypothesis that the mean excess return in subperiod one was less than or equal to that of subperiod two, a pooled-variance t-statistic for the difference in the means was computed. This t-statistic was 5.46. Since the critical value for the t is 2.326 at a 99% confidence level, the null hypothesis that the mean excess return in subperiod one is less than or equal to that in subperiod two cannot be ac-cepted. The parametric tests, then, provide evidence

that although excess returns existed over the entire decade of the 1980s, the degree of excess returns decreased after the enactment of the Tax Reform Act of 1986. This is consistent with the predictions of the tax-based underpricing model.

Testing the Tax Change Effect:

Nonparametric Tests

In order to test via nonparametric methods whether underpricing existed in the two subperi- ods a pair-wise sign test was computed. The percentage change in the IPO price (offer price to price of first trade) was paired with the percentage change in the OTC Industrial Index that

558 M. A. RESIDE,R. M. ROBINSON,A. J. PRAKASH AND K. DANDAPANI

corresponded to the same time period. If the percentage change in the IPO price was greater than that of the Index, then a '+'was recorded; if it was less than the Index then a '-'was recorded. See Conover (1980, p. 124), Freund (1971, p. 3441, or Anderson et al. (1981, p. 418) for explanations of this test. The number of positive observations in the first

subperiod was 632, and n was 871. The critical value for to,,, was 470 (z,,,, = 2.326 for a= 1%). Since 632 > (871 - 4701, the null hypothesis that no underpricing exists in this subperiod cannot be accepted as the 99% confidence level. The number of positive observations in the sec-

ond subperiod was 185 and n was 143. The critical value for to,,, was 240 (z,,,, = 2.326 for a= 1%). Since 185 > (243 - 140), the null hypothesis that no underpricing exists in this subperiod also cannot be accepted at the 99% confidence level. The Mann-Whitney U-test is a nonparametric

method used to test the hypothesis that two samples are drawn from identical populations. See Freund (1971, p. 347) and Conover (1980, p. 216) for statistical detail.' In this test the two samples are arranged jointly as though they comprise one sample, and ranks are assigned, largest to smallest. Tied observations are assigned the mean of the two spanned ranks. The sum of the ranks of one of the samples is then compared to a critical value in order to test the hypothesis. The sum of the ranks of the first subperiod is

676,535. The Mann-Whitney test statistic, which is defined by a standard normal z-statistic, is 26.10. The null hypothesis that the samples are drawn from identical distributions cannot be accepted at any meaningful level of significance. The alternative hypothesis that the underpricing is greater for the first subperiod than for the second cannot be rejected.

Multivariate Analysis

Numerous multiple regression analyses of IPO excess returns have been presented in the literature. The independent variables included in the regression, however, have varied greatly. Logue (1973) included the number of IPOs offered dur- ing the issuing month, a Department of Commerce 'Diffusion Index of Common Stock Prices', a dummy variable to indicate whether or not the 'speculative' label was required by the SEC, and cash and noncash compensation included sepa-

rately. Unadjusted IPO returns were used as the dependent variable. Separate regressions were computed for ranked versus nonranked under- wr i t e r~ .~For the entire sample, only the diffusion index and the total value of the issue were found to have regression coefficients that are signifi-cantly different from zero. Bear and Curley (1975) included the age of the

firm, the value of the issue, the preceding year's earnings, the percentage of cash compensation and the firm's ex post beta, as explanatory variables. Unadjusted IPO returns were the dependent variable. The regression coefficients for the firm's ex post beta and noncash compensation were significantly different from zero. The ex post beta inclusion is of questionable theoretical valid- ity, particularly for the purpose of this study, since it could not have been known a priori by the financial markets given that the issues are IPOs. Tinic (1988) included the reciprocal of the of-

fering value, the natural log of the offering value, and dummy variables for ranked uersus non-ranked underwriters and for issuing in the month of January. The dependent variable was market- adjusted returns. Only the coefficient for the reciprocal of the offering price was significantly different from zero. Beatty and Ritter (1986) included the reciprocal

of the offering price and an underwriter prestige index as independent variables, along with the stated number of uses for the funds raised as a proxy for uncertainty concerning the returns to the investor. The latter variable was found to have no effect. The coefficient for the reciprocal of the offer price was significantly different from zero. The dependent variable was the market-adjusted rate of return. The regressions below use the initial market-ad-

justed rate of return as the dependent variable. The independent variables include the firm's age, the value of the firm's assets, its debt/asset ratio, the issue value, the underwriter's ranking as in- dexed in Carter and Manaster (1990) and a dummy variable of '1' for issues after June 1986 and '0' for those issued b e f ~ r e . ~ The real value of the firm's assets and issue size are also included. In addition, because the pricing model pre-

sented above shows that IPO prices should be dependent upon interest rates via discount factors, an attempt was made to use BBB and AAA bond indexes as independent variables. Because of the general decline in interest rates over the


later years of the 1980s, however, these rate indexes were highly correlated with the dummy variable. The decrease in marginal tax rates that were implemented due to the Tax Reform Act would cause the supply of loanable funds to increase and rates to fall. This would result from the increase in after-tax rates. The correlation coefficient between BBB yields and the dummy variable was -0.72, and between AAA yields and the dummy variables it was -0.71. Using either of these rates along with the dummy variable would cause severe multicollinearity problems and make it impossible to discern the effect of the dummy variable from the rate indexes. Hence, the indexes were omitted from the regression^.^ For the purpose of examining possible multi-

collinearity problems with the independent variables, Table 1presents the correlation coefficient matrix of the variables used in the regression. As shown, the dummy variable has a correlation coefficient of 0.20 with the underwriter ranking variable. This slight degree of collinearity has the potential to partially obscure the influence of each upon the dependent variable. The dummy variable also has a slight correlation with the value of the assets and the issue value. These correlations are probably, in part, due to the inflationary trend of the 1980s where the value of the assets and the issue value increased in nomi-

nal terms over the decade. Deflating these variables by the CPI lowered their correlations. The more serious correlation problem exists between the underwriter ranking variable and the value of the assets and issue. Deflating these variables lowered the correlations slightly. The five regressions computed and reported in

Table 2 show that the underwriter ranking, debt- to-asset ratio, dummy variable and the age of the firm had coefficients that were significantly different from zero at high probability levels. By the magnitude of the coefficients, the debt/asset ra-tio had the largest impact on the IPO returns. The returns are measured as percentages, hence a change in the debt/asset ratio from 0.5 to 0.6 has an impact of -2% on the rate of return. This finding is consistent with James (1992). The dummy variable has the second-largest impact, with regression coefficients of about -6, which means that the mean excess return for IPOs fell by 6% after the Tax Reform Act was imple-mented. The underwriter ranking variable and the third-largest impact, with coefficients of about -3. This indicates that a ranking of 9 causes excess returns to be, on average, lower by 27% as compared to underwriter rankings of 0. In three of the regressions, however, the dummy variable had significance levels of 98% rather than the

Table 1. Correlation Coefficients of Regression Variables

RANK TA D / A DUM AGE VAL RET

RANK TA D /A DUM AGE VAL RET -RVAL RTA

aSignificantly different from zero at 99% confidence level. b~ignificantlydifferent from zero at 95% confidence level.

RANK:Prestige ranking of the managing underwriter, 0 to 9, according to Carter and Manaster (1990). TA: Total pre-offer assets of the IPO firm ($ millions). D/A: Pre-offer debt-to-asset ratio of the IPO firm. DUM: Dummy variable to '0'prior to 7/86,or '1' after 6/86. AGE: Age of the IPO firm measured in whole years, 0 for firms of age less than one year. VAI: Total value of the issue ($ millions). RET: IPO initial excess return (%), offer price to first trade price. R V L : Value of the issue divided by the CPI ($ millions). RTA: Value of assets divided by the CPI ($ millions).

M. A. RESIDE, R. M. ROBINSON, A. J. PRAKASH AND K. DANDAPANI

Table 2. OLS Regression Coefficientsa

RANK

TA

D /A

DUM

AGE

VAL

RVAL

RTA

R~

t-statistics are in parentheses. "The dependent variable is the market-adjusted return (RET). bThe regression coefficient is significantly different from zero at the 99% confidence level. 'The regression coefficient is significantly different from zero at the 98% confidence level.

99% probability levels for the other significant variables. The negative signs of the coefficients for the

dummy variable, the ranking variable and the age of the firm are all consistent with theoretical predictions. Since the Tax Reform Act lowered the capital gains tax rates, it is expected that IPO returns should decrease, as predicted by the tax- based pricing model. This is consistent with the negative coefficient. The use of higher-prestige underwriters should

lower the rate of return of the issue in the after- market. That is, as suggested in previous studies, IPOs should be underpriced to a lesser extent if higher-ranked underwriters are used by the issuing firm. The negative regression cofficient is consistent with this prediction. An increase in the firm's age should also lower the IPO return since more should be known by the financial markets about the older firms; hence; uncertainty is lower for older firms. The negative coefficient on the debt/asset ratio

is not, however, clearly explained by theory. It might be expected that the greater the debt ratio,

the greater the uncertainty as to the future returns to the IPO issue holder, and, therefore, the greater the return required by the financial markets. It could be, however, that those IPO firms that previously had issued debt are better known to the financial markets, possibly favorably af- fecting the acceptance of their public equity issue. This could explain the negative coefficient.

SUMMARY AND CONCLUSIONS

A theory of tax-based IPO underpricing is presented above. An entrepreneurial wealth-maximizing model is given that shows that deferred capital gains taxes, combined with currently due ordinary income taxes, could partially account for IPO underpricing. The model explicitly predicts that an increase in the capital gains tax rate, ceteris paribus, should result in a lower degree of underpricing. The Tax Reform Act of 1986 provides an oppor-

tunity to test this tax-based underpricing hypothesis since the Tax Reform Act raised the capital

UNDERPRICING OF IPOS 561

gains tax rate. It is shown that the distribution of excess returns did shift about the implementation date of the Act, and in the direction predicted by the model. This shift is verified by both parametric and nonparametric statistical methods. In addition, regression analyses that control for other possible underpricing factors and that allowed the IPO returns to shift about the Reform Act's implementation date via a dummy variable con- firms the predicted tax effect. The empirical evidence examined is therefore consistent with the predictions of the tax-based pricing model.

Acknowledgements We would like to thank an anonymous reviewer for the constructive comments we received on the earlier versions of the paper. Any remaining errors are our sole responsibility.

NOTES

1. The Mann-Whitney U-test is appropriate for samples of unequal size.

2. Among others, Logue (1973) and Tinic (1988) have provided descriptions of 'ranked versus nonranked' (or 'prestigious versus nonprestigious') underwriter groupings. Briefly, the classifications loosely follow the description given by Hayes (1971), where underwriters listed at the top of a tombstone have had higher rank than those at the bottom. Higher rank is synonymous with higher stature or prestige in the underwriting community.

3. The inclusion of the debt/asset ratio should provide more information to the regression than a dummy variable for the presence of debt, as employed by James (1992). James found a significant and negative relationship between IPO underpricing and the presence of debt in the firm's capital structure at the time of issue. A value of '1' was assigned to the dummy variable for firms with debt and '0' for firms without debt. The finding suggests that if a firm has previously issued debt, the IPO is underpriced to a lesser extent than if the firm has not issued debt.

4. By orthogonalizing collinear variables, some re-searchers have attempted to discern their relative influences (see Singh et al., 1991). This assigns one variable to the orthogonalized residual, however, and the choice of assignment is arbitrary. It does not separate the true explanatory power of each.

REFERENCES

D. R. Anderson, D. J. Sweeney and T. A. Williams (1981) Introduction to Statistics: An Applications Ap- proach, St Paul: West Publishing.

R. M. Bear and A. J. Curley (1975) Unseasoned equity financing Journal of Financial and Quantitatiue Analy- sis, 311-25.

R. P. Beatty and J. R. Ritter (1986) Investment banking, reputation, and the underpricing of initial public offerings Journal of Financial Economics, XV, 213-32.

S. Block and M. Stanley (1980) The financial characteristics and price movement patterns of companies approaching the unseasoned securities market in the late 1970's Financial Management, 30-36.

R. Carter and S. Manaster (1990) Initial public offerings and underwriter reputation Journal of Finance, XLV, September, 1045-64.

W. J. Conover (1971) Practical Nonparametric Statistics, New York: John Wiley.

K. Dandapani, R. Dossani, A. J. Prakash and M. A. Reside (1992) Personal taxes and the underpricing of initial public offerings Managerial and Decision Economics, July-August, 279-286.

J. E. Freund (1971) Mathematical Statistics, 2nd edn., Englewood Cliffs, NJ: Prentice-Hall.

S. L. Hayes I11 (1971) Investment banking: power structure in flux Haruard Business Review, March-April, 136-52.

C. James (1992) Relationship-specific assets and the pricing of underwriter services The Journal of Fi- nance, XLVII, 5, 1865-85.

J. Johnston (1972) Econometric Methods, 3rd edn., New York: McGraw-Hill.

D. E. Logue (1973) On the pricing of unseasoned equity issues: 1965-1969 Journal of Financial and Quantitative Analysis, 91-103.

J. G. McDonald and A. K. Fisher (1972) New-issue stock price behavior The Journal of Finance, 97-102.

B. Neuberger and C. A. LaChapelle (1983) Unseasoned new issue price performance on three tiers: 1975-1980 Financial Management, 23-8.

J. R. Ritter (1984) The 'hot issue' market of 1980 Journal of Business, LVII, 2, 215-40.

A. K. Singh, R. Cowan and N. Nayar (1991) Underwrit- ten calls of convertible bonds Journal of Financial Economics, XXIX, 173-96.

H. R. Stoll and A. Curley (1970) Small business and the new issues market for equities Journal of Financial and Quantitative Analysis, V, 309-22.

S. M. Tinic (1988) Anatomy of initial public offerings of common stock The Journal of Finance, XLIII, 4, 789-822.

You have printed the following article:A Tax-Based Motive for the Underpricing of Initial Public OfferingsMary Ann Reside; Richard M. Robinson; Arun J. Prakash; Krishnan DandapaniManagerial and Decision Economics, Vol. 15, No. 6. (Nov. - Dec., 1994), pp. 553-561.Stable URL:http://links.jstor.org/sici?sici=0143-6570%28199411%2F12%2915%3A6%3C553%3AATMFTU%3E2.0.CO%3B2-L

This article references the following linked citations. If you are trying to access articles from anoff-campus location, you may be required to first logon via your library web site to access JSTOR. Pleasevisit your library's website or contact a librarian to learn about options for remote access to JSTOR.

Notes

2 On the Pricing of Unseasoned Equity Issues: 1965-1969Dennis E. LogueThe Journal of Financial and Quantitative Analysis, Vol. 8, No. 1. (Jan., 1973), pp. 91-103.Stable URL:http://links.jstor.org/sici?sici=0022-1090%28197301%298%3A1%3C91%3AOTPOUE%3E2.0.CO%3B2-C

References

Unseasoned Equity FinancingRobert M. Bear; Anthony J. CurleyThe Journal of Financial and Quantitative Analysis, Vol. 10, No. 2. (Jun., 1975), pp. 311-325.Stable URL:http://links.jstor.org/sici?sici=0022-1090%28197506%2910%3A2%3C311%3AUEF%3E2.0.CO%3B2-G

Initial Public Offerings and Underwriter ReputationRichard Carter; Steven ManasterThe Journal of Finance, Vol. 45, No. 4. (Sep., 1990), pp. 1045-1067.Stable URL:http://links.jstor.org/sici?sici=0022-1082%28199009%2945%3A4%3C1045%3AIPOAUR%3E2.0.CO%3B2-H

http://www.jstor.org

LINKED CITATIONS- Page 1 of 2 -

NOTE: The reference numbering from the original has been maintained in this citation list.

Personal Taxes and the Underpricing of Initial Public OfferingsKrishnan Dandapani; Rafiq Dossani; Arun J. Prakash; Mary Ann ResideManagerial and Decision Economics, Vol. 13, No. 4. (Jul. - Aug., 1992), pp. 279-286.Stable URL:http://links.jstor.org/sici?sici=0143-6570%28199207%2F08%2913%3A4%3C279%3APTATUO%3E2.0.CO%3B2-7

On the Pricing of Unseasoned Equity Issues: 1965-1969Dennis E. LogueThe Journal of Financial and Quantitative Analysis, Vol. 8, No. 1. (Jan., 1973), pp. 91-103.Stable URL:http://links.jstor.org/sici?sici=0022-1090%28197301%298%3A1%3C91%3AOTPOUE%3E2.0.CO%3B2-C

The "Hot Issue" Market of 1980Jay R. RitterThe Journal of Business, Vol. 57, No. 2. (Apr., 1984), pp. 215-240.Stable URL:http://links.jstor.org/sici?sici=0021-9398%28198404%2957%3A2%3C215%3AT%22IMO1%3E2.0.CO%3B2-O

Small Business and the New Issues Market for EquitiesHans R. Stoll; Anthony J. CurleyThe Journal of Financial and Quantitative Analysis, Vol. 5, No. 3. (Sep., 1970), pp. 309-322.Stable URL:http://links.jstor.org/sici?sici=0022-1090%28197009%295%3A3%3C309%3ASBATNI%3E2.0.CO%3B2-C

http://www.jstor.org

LINKED CITATIONS- Page 2 of 2 -

NOTE: The reference numbering from the original has been maintained in this citation list.

A Tax-based Motive for the Underpricing of IPO

Documents

Transcript of A Tax-based Motive for the Underpricing of IPO