IPO Under Pricing

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1 IPO Underpricing and Short run Performance in Bangladesh: Determinant Attribution and Explanation By- M. A. Faisal Mahmud ID- 10-180 10 th Batch (BBA Program) Department of Finance University of Dhaka Under Supervision of – Dr. A. H. M. Habibur Rahman Professor Department of Finance University of Dhaka [ This is an Internship Report prepared in partial fulfillment of the requirements of Bachelor of Business Administration Program ]

Transcript of IPO Under Pricing

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IPO Underpricing and Short run Performance in Bangladesh:

Determinant Attribution and Explanation

By-

M. A. Faisal Mahmud

ID- 10-180

10th Batch (BBA Program)

Department of Finance

University of Dhaka

Under Supervision of –

Dr. A. H. M. Habibur Rahman

Professor

Department of Finance

University of Dhaka

[ This is an Internship Report prepared in partial fulfillment of the

requirements of Bachelor of Business Administration Program ]

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Letter of Transmittal

March 31, 2009

Mr. Dr. A. H. M. Habibur Rahman

Professor

Department of Finance

University of Dhaka

Dhaka-1000

Subject: Submission of the Intern report.

Dear Sir

This is the exceptionally overwhelming experience of submitting the thesis report

which I have prepared with my hard work and being driven by the urge as a finance

student always put up with on. I joined Securities and Exchange Commission (SEC)

for the internship and worked on various departments. Finally I endowed myself in

study about IPO Underpricing and empirical experiment in the context of Bangladesh.

This report has attempted to focus on the IPOs experienced the market from 2005 to

2008 and judged how far they are underpriced. I have prepared this report with the

best feasible ways as well as have tried to make it as sound as possible.

Hence, I would like to take this opportunity to request you to kindly go through the

report and scrutinize how far I have been successful in my effort.

Truly Yours

M. A. Faisal Mahmud

Roll: 10-180

10th Batch

Bachelor of Business Administration (BBA) Program

Department of Finance

University of Dhaka.

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Acknowledgement

I am deeply indebted to my supervisor Prof. Dr. A. H. M. Habibur Rahman whose

help, stimulating suggestions and encouragement helped me in all the time of research

for and writing of this thesis. I would pay my gratitude to Mr. Dr. Professor Mahmood

Osman Imam who supported me in my work by providing help, support, interest and

valuable hints.

Special gratitude is extended to all of the Securities and Exchange Commission (SEC)

employees for their contributions while I conducted extensive pre-site discussion,

prepared the summary of the pre-site visit data, recorded and paraphrased the

departments’ responses, and organized this phase of the report from the beginning

through the end.

Recipients of the report are encouraged to share the information herein broadly in the

hope that the observations presented will promote the further development of IPO

pricing issue in Bangladesh.

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Table of Contents

Abstruct……………………………………………………………………………… i

Study covered…………………………………………………………………. ii

Part I

Purpose of the study……………………………………………………………iii

Rationale of the study………………………………………………………… iii

Scope of the study……………………………………………………………...iii

Limitation of the study…………………………………………………………iii

Introduction……………………………………………………………………..1

Part II

Empirical Evidence and Literature Review…………………………………….2

Theoretical ground……………………………………………………………...4

Part III

The Market……………………………………………………………………..14

Experiment Data ………………………………………………………………16

Experiment Methodology……………………………………………………...18

Pert IV

Results of Experiment………………………………………………………….22

Part V

Determinants Attribution ………………………………………………………27

Explanation……………………………………………………………………..31

Part VI

Towards pricing efficiency…………………………………………………….34

Book Building: a new era……………………………………………………...35

FCF inclusion in Fixed Price method is a growing demand…………………..39

Part VII

Conclusion…………………………………………………………………….41

Part VIII

Appendix 42

Reference: 55

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List of tables

DSE in last 4 Years……………………………………………………………15

Initial return percentage……………………………………………………….22

Descriptive Statistics for the 32 IPOs…………………………………………24

Correlations…………………………………………………………………...28

Model Summary(b)…………………………………………………………...29

ANOVA(b)……………………………………………………………………29

Coefficients(a)…………………………………………………………………30

Coefficient Correlations(a)……………………………………………………52

Collinearity Diagnostics(a)……………………………………………………53

Residuals Statistics(a)…………………………………………………………54

Underwriter Reputation and Ranking…………………………………………46

Money Left on the Table at First Day…………………………………………47

List of figures

IPO pricing phenomenon……………………………………………………..13

Market condition judgment…………………………………………………...16

Sector representations in IPOs………………………………………………..17

Return by issue size…………………………………………………………..22

Return by underwriter’s prestige……………………………………………..23

Return by market condition…………………………………………………..23

Year wise Return……………………………………………………………..23

Losers and winners…………………………………………………………...24

P/E comparisons……………………………………………………………...25

Daily aftermarket return……………………………………………………...26

Cumulative holding period return……………………………………………26

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Abstract

This paper empirically examines the underpricing and the short run performance of

IPOs in Bangladesh. In an effort to minimize the practice of underpricing and to probe

the reasons behind it, this study compares the offer price against actual stock market

performance one month after listing. Results indicate that the IPOs are under-priced

as is evidenced by the positive listing day returns and can’t out perform the market in

the subsequent period almost up to 30 days.

The average underpricing of Bangladeshi IPOs is 221.38%, the highest of any major

world market. Using a sample of 32 IPOs listed on the Dhaka Stock Exchanges

between 2005 and 2008, I examine empirically the determinants of this extreme level

of underpricing. I find it is caused partly by the information asymmetry recompense,

high demand due to the shortage of alternative investment opportunities, the

ignorance of the investors, the pricing alternatives constraints. The result can be

explained as a carrot to induce the primary market share holders in secondary market

as the market here is emerging.

Book-building method will be adopted by the SEC. It will be used by higher quality

issues and will reduce uncertainty in valuation, and with reduced under-pricing of

issues. I recommend the issuer should be allowed to value the issue using the FCF

method so that the growth prospect of the firm is not ignored.

However, I can not be fully emphatic about my finding because of a small sample

size.

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Study covered

Firstly, how much IPOs are Underpriced and how they Perform in Short Run in

Bangladeshi Equity Market.

Secondly, As frequently seen IPOs are normally Underpriced in Bangladesh, should

we go for pricing efficiency, if YES then how far should SEC be concerned with

introducing new methods of pricing

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Purpose of the study

Bangladeshi capital market is juvenile and does not have many characteristics of

developed market. So just relying on empirical performance of major capital market

to judge a rough estimation short term return pattern of Initial Pubic Offer is

imprudent. That’s why I tried to reveal the return pattern of the IPOs of Bangladeshi

capital marker. The purpose of the study is basically judge how far the equities here in

Bangladesh is underpriced and judge the short run performance of the securities. The

paper endeavored to find the determinants of the short run return.

Rationale of the study

The emerging capital market of Bangladesh is getting the increased concentration any

time ever and the capitalization has been doubled last year with a growth rate of

135.28%. That’s why as of late market requires more efficient regulatory framework

and co operation to maintain its stability. Apart from theoretical ground this literature

will allow the readers to assess the short tern return of the IPOs. It’s prudent to go

through the market at a glance before investing in an IPO.

Scope of the study

The study encompasses the IPOs of Dhaka Stock Exchange from 2005 – 2008 tenure

and all 32 samples are from equity. The study includes return series analysis and

multiple regression analysis to determine the factor behind the underpricing.

Limitation of the study

Just being constrained by the time I can’t take a large sample to evaluate the IPOs

return. I guess a 3 year period is not adequate to comment that the market will award

you like 200% return. I should have attribute different other models and significance

test of abnormal profit from the market, but with this sample the result will not be that

much representative. The sample is dominated by a bit hot IPO tenure and strong

dominance of Banking and Insurance Sector. The sample does not cover the sectors

like Pharmaceuticals, Textiles, Food and Allied or IT.

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Introduction

Valuation has seen a constant debate between what something is worth versus what

the market thinks its worth and versus what a strategic or motivated buyer thinks its

worth. Initial Public Offerings (IPOs) provide a significant abnormal return in the

initial days of trading is the most investigated anomalies in finance. This anomaly has

been well documented in almost all the financial markets of the world (Jenkinson and

Ljungqvist (1996)). While a number of theories have been put forward to explain this

anomaly, the academics are undivided in their conclusions that the presence of

abnormal returns shows evidence of deliberate underpricing.

I reported underpricing of IPOs as by offering type, by underwriter reputation, by

industry type, in hot and cold markets. Various determinants like the Issue Sige, Age

of the Firm, Sponsors Share holdings, Total asset, Profitability of the firm, market

condition and the risk of the security has been tested to identify the extent of

dependence of the return.

Amongst other determinants the pricing method followed in the IPO process is also

important. Performance of IPO depends on the investors expectation of the stock,

which is difficult to estimate properly. The rough the estimation, the inefficient price

will be determined. That’s why, underpricing is severe in the country like Bangladesh

where stocks come to the market using fixed method (in practical strong dominance

of NAV method). Thus the issuer is relying only on accounting data where the growth

prospect of the firm and market’s expectation of the scrip is severely ignored.

In this paper I test the determinants of IPO underpricing and evaluated the short term

return pattern of the IPOs from the period of 2005 and 2008. All of the IPOs in the

sample came to the market with a fixed price offering.

The Methodology adopted follows in Pat III and empirical results are presented in

section IV and results are clarified in section VI.

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Empirical Evidence and Literature Review

In Bangladesh there is hardly any literature worked on short run IPO performance

issue. Never-the-less few scholars, basically academicians have worked on broad

heading of IPO. These among others includes-

Prof. Dr. Mahmood Osman Imam from Department of Finance, University of Dhaka

worked on "Volatility in the Stock Return: Evidence from Dhaka Stock Exchange

(2003)" and another article titled "The Pricing of Initial Public Offerings: Theory and

Evidence (1998)”.

Prof. Mohammad Sadiqul Islam and Sirajum Munira from Department of Finance,

University of Dhaka has worked on “IPO Flipping and its Determinants in

Bangladesh (2004)”. In their paper, they attempted to determine the degree of IPO

flipping and to investigate the factors that explain IPO flipping in Bangladesh. Based

on a sample of on 96 IPOs in Bangladesh during the period between January 1994 and

December 2001, they documented that the average IPO flipping has been 29.67

percent in the first week, 74.21 percent in the first month and 177.3 percent in the first

three months in the initial aftermarket. They reported that the size of the issue has

significant negative influence and the institutional participation in the issue has

significant positive influence on IPO flipping. In addition, they also find that flipping

is relatively lower in the hot issue market and that flipping varies significantly in

different sectors.

Amirus Salat (University of Dhaka), Mohammad Mominul Hoque Bhuiyan (Asian

University of Bangladesh), Muhammad Zahedur Rahman (Eastern University) have

worked on “Performance Evaluation of the Companies After Initial Public Offerings

(2004)”. They examined the operational performance of companies after IPO in

Bangladesh based on a sample of eight companies taken from 1999 to 2000 IPO's out

of eighteen companies during that period and reported that “most of the companies

made optimistic forecast in their prospectus during the IPO”. They made an attempt to

find that whether they are able to reach their desire expectations. They have studied

the post IPO performance of the companies in the respect of project implementation,

fund utilization, IPO expense, holding of Annual General Meeting, penalization

imposed by Securities and Exchange Commission, payment of dividend etc. The

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study shows that the performances of most of the companies were not satisfactory as

per above criteria.

Dr. Musa and Dr. Mujibul Hoque worked on " An explanation of IPO Underpricing,

Test of Asymmetric Information Hypothesis: Evidence from DSE (2003)".

But globally Short run underpricing has gone through extensive observation and

found that regardless of the method of pricing, IPOs tend to yield substantial returns

in the days (and sometimes weeks) immediately following issue.

Previous studies have shown that the IPOs of common stock yield positive short-run

raw returns (Rock, 1986; Jog and Riding, 1987; Tinic, 1988, Finn and Higham, 1988;

Ritter, 1991; Keasey and Short, 1992; Levis, 1993; Kunz and Aggarwal, 1994; Lee,

Taylor and Walter, 1996).

The positive short-run returns documented in the literature are interpreted as an

evidence of underpricing in the offer price. Carter and Manaster (1990) develop an

equilibrium model that explains the relationship between this underpricing and the

prestige of the underwriter who brings the issue to the market. According to their

model, prestigious underwriters (those with high reputation) are associated with lower

amounts of IPO underpricing. Since the early 1970s, several studies have tested this

argument by using different measures of underwriter reputation (McDonald and

Fisher, 1972; Block and Stanley, 1980; Neuberger and LaChapelle, 1983; Beatty and

Ritter, 1986; Johnson and Miller, 1988; Carter and Manaster, 1990; Booth and Chua,

1996; Nanda and Yun, 1997; Carter, Dark and Singh, 1998. Similar to results from

developed markets, several studies document positive abnormal initial day IPO

returns in emerging markets (Dawson, 1987; Aggarwal, Leal and Hernandez, 1993;

Lee, Taylor and Walter, 1996b). On the other hand, several characteristics of

emerging markets might cause the relationship between underwriter reputation and

IPO performance in these markets to be different than the relationship observed in

developed markets (Harvey, 1995). It is usually argued that the information

asymmetry is severe and the informational efficiency is low in emerging markets.

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A summary of initial returns in major markets:

Ritter (1987), Welch (1989), Ibbotson (1994) and Rajan and Servaes (1997) among

others provide evidence suggesting that the existence of average initial returns of up

to 16% has been a regular feature of the US new issue market.

Lee (1994), Jacquillat (1986), Kaneko and Pettway (1994) and Ljungqvist (1997)

among others provide evidence of abnormal returns of up to 14% in the developed

markets of the world such as Australia, France, Japan and Germany.

For British IPOs, the studies of Dimson (1979), Buckland (1981), the Bank of

England (1990), Jenkinson and Mayer (1988) and Levis (1993) indicate average first

day returns ranging from 8.6% to 17%.

Country specific initial return emerged from Empirical works as Brazil 78.5%,

Finland 9.6%, India 35.3%, Japan 32.5%, Korea 78.1% and usually Smaller offerings

underpriced by more than larger ones.

Theoretical ground

An IPO can be a risky investment. For the individual investor, it is tough to predict

what the stock or shares will do on its initial day of trading and in the near future

since there is often little historical data with which to analyze the company. Also,

most IPOs are of companies going through a transitory growth period, and they are

therefore subject to additional uncertainty regarding their future value. This

uncertainty should provide reward to risk taker.

Concerning the general issue of underpricing, it appears that there is a player in each

party who is incentivized to underprice. The investment bank views underpricing as a

form of compensation. The insider, or manager, has personal wealth incentives, and

the outsider, or hired party (investment bank) is incentivized as well.

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Besides empirical evidences the dominant theories explain underpricing are like the

followings-

- It is obvious that some firms “good” and some “bad” in the economy. Firms

cannot reveal this credibly so price is same for all firms. Informed investors can

tell “good” firms from “bad” but uninformed cannot identify and thus Informed

investors only buy “good” firms. Typically all buyers of “bad” firms are

uninformed, buyers of “good” firms are mixed (rationing). If price is fair

(averaged over all firms), informed investors have positive returns, uninformed

have negative return. Since uninformed buyers know this, they demand all

firms to be underpriced to compensate them as explained by Rock (1986). It is

the famous winner’s curse model.

- Investment bankers often underprice IPOs to get investors with private info to

truthfully reveal valuations as explained by Benveniste and Spindt (1989)

- Cascades Hypothesis states that Investors normally pay attention to world

around them. If no one else willing to buy, even investor with positive info may

not enter in the market. That’s why Banks often underprice to get first few

investors to buy, hope to start a cascade or a snowball effect. Underpricing is

like paying to advertise and build a brand name here, as explained by Welch

(1992)

- Bank has monopsony power, superior knowledge of market conditions than

firm and Underpricing is the “price” firm pays to bank. And usually Bank uses

underpricing to reward its clients and build relationships. It Works because of

rationing and Clients most often purchase other services, pay high fees as

explained by Baron and Holmstrom (1980)

- Anyone who signs prospectus is usually liable and Underpricing is one way to

avoid lawsuits. However, as empirically found - 93 IPOs that were

subsequently involved in lawsuits had similar initial returns to control firms that

were not sued as stated by Drake and Vetsuypens (1993)

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- Underpriced issues leave a good taste with investors, allowing firm to sell

future offerings at higher price. Good firms willing to underprice because they

will recoup underpricing in subsequent offerings, as explained by Welch (1989)

- Some countries (obviously Bangladesh) require offer prices set based on book

values. Book values do not take into account growth opportunities, therefore

IPOs are underpriced.

- Banks buy lots of shares in immediate after market to prevent price from

falling. This drives initial prices up, as explained by Ruud (1993). Firms

intentionally underprice in order to have many small dispersed owners. This

both increases liquidity and makes takeovers more difficult. Again If there is

some segmentation between IPO market and broad market, than purchasers

may need extra premium for bearing risk then there exists market

incompleteness.

- Underwriter bears all risk for IPO since agrees to buy at some predetermined

price and Underwriter usually underprices to reduce risk of getting stuck with

an unsuccessful issue. This implies riskier issues have most underpricing. This

is confirmed by several studies - Reilly and Hatfield (1969), Stoll and Curley

(1970), McDonald and Fisher (1972), Reilly (1973), and Bear and Curley

(1975).

- Entrepreneurs care more about change in their wealth than level of wealth. In

IPOs, wealth loss from initial underpricing less than gain on retained shares by

preissue shareholders. Those IPOs that leave money on the table are

simultaneously discovering that they are wealthier than they expected because

the shares gained value as explained by Loughran and Ritter (2002)

- Tinic (1988) suggests that IPO underpricing serves as a form of insurance. He

demonstrates that gross underpricing serves as an efficient form of protection

against legal liabilities and the associated damages to the reputations of both the

investment bankers and the issuers. In other words, this hypothesis posits an

implicit contract between issuers, underwriters and investors. Under this

implicit contract, the investors are provided with excess returns as an ‘insurance

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premium’ in return for which they are willing to overlook small errors (e.g.,

related to the disclosure requirements of the securities regulations) without

taking recourse to the courts.

- As noted by Aggarwal, Krigman and Womack that to minimize their risk of

holding unallocated shares investment bankers need sufficient reward. And

obviously compensation should be provided to clients who supply the bank

with substantial business. Rock (1986) suggests that IPO returns are required by

uninformed investors as compensation for the risk of trading against superior

information.

- Another factor was well noted by Habib and Ljungqvist that “Some IPOs are

more underpriced than others because their owners have less reason to care

about underpricing.” This idea examines the extent to which “issuers care about

underpricing.” They note, “issuers care about underpricing primarily to the

extent that they [personally] participate in the offering. The more shares they

sell, the greater their incentive to decrease underpricing.”

A company that is planning an IPO appoints lead managers to help it decide on an

appropriate price at which the shares should be issued. Companies can be floated in a

variety of ways. The choice tends to be influenced by the size of the company, its

riskiness and the institutional and regulatory arrangements in each particular country

There are two ways in which the price of an IPO can be determined: either the

company, with the help of its lead managers, fixes a price or the price is arrived at

through the process of book building.

In Fixed Price Method the investment bank in consultation with the firm fixes the

price at which an investor can subscribe to. This price could be at par value or at a

premium above the par value.

Book Building Method on the other hand fixes a price band instead of a fixed price.

The lowest price in the price band is called as ‘floor price’ and the highest price is

called as ‘cap price’. An investor can subscribe at a price anywhere in the price band.

An investor who wants to subscribe at any price can mention the ‘cut-off price’. This

cut-off price is decided once the bid period is over. Once the issue is closed a book

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with descending order of prices is prepared. Cut-off price is the price at which the

entire issue gets subscribed. This is the most commonly used method.

In book building mechanism, during the period for which the book for the offer is

open, the bids are collected from investors at various prices, which are within the

price band specified by the issuer. The process is directed towards both the

institutional as well as the retail investors. The issue price is determined after the bid

closure based on the demand generated in the process. Bookbuilding has been widely

adopted in international markets since the early Nineties, Evidenced by Ljungqvist,

Jenkinson, and Wilhelm (2003) and Sherman (2001) for a discussion of global trends

in IPO selling methods.

Bookbuilding vs. Fixed Price:

Fixed price offerings are priced without first soliciting investor demand, with price

discovery taking place mainly in the aftermarket. In contrast, bookbuilding involves

road shows and one-to-one meetings with potential investors that allow the

underwriter to ‘discover’ investor valuations prior to setting the offer price.

Both methods require that money be left on the table for investors in the form of

underpricing. Underpricing is needed in fixed price offerings in order to compensate

the uninformed retail investors for the winner’s curse they face as informed investors

crowd them out of good deals (Rock, 1986). While the winner’s curse is not a concern

in bookbuilding -- because the underwriter solicits investor information prior to

pricing -- a discount is still required to reward investors for surrendering information

(Benveniste and Spindt, 1989).Several papers have compared in theoretical settings

the underpricing required under the two methods, and the consensus finding has been

that bookbuilding requires on average a lower discount (e.g., Benveniste and

Wilhelm, 1990, Spatt and Srivastava, 1991, Benveniste and Busaba, 1997, and Biais

and Faugeron-Crouzet, 2001).

Investors who possess information about the value of an IPO can participate in the

offering as well as trade strategically in the aftermarket. Both the bookbuilding and

the fixed price IPO selling methods require more underpricing when aftermarket

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trading by informed investors is considered. Bookbuilding becomes especially costly,

since the potential for profit in the aftermarket adversely affects investors’ bidding

behavior in the premarket. Unless the underwriter building a book can target a small

enough subset of the informed investors, a fixed price strategy that allocates the issue

to retail investors produces higher proceeds on average, contrary to the conventional

wisdom in the literature.

The only way an investor benefits from possessing information is through receiving

allocations of shares in IPOs. Put differently, an informed investor who does not

participate at the IPO stage cannot make money by trading in the aftermarket. This

assumption, however, is in sharp contrast to the fundamental premise underlying the

market microstructure literature, which focuses on the trading behavior of, and the

profit made by, informed investors. It also prohibits the consideration of the IPO

process as a sub game within a broader context in which informed investors can

choose to participate in the premarket of an IPO, wait until the aftermarket and then

trade on their information, or do both.

The inability of informed investors to generate profits in the aftermarket is of

paramount importance in the design of the price/allocation rule in the existing

bookbuilding models. In these models, the investment banker, on behalf of the issuing

firm, attempts to gather investor feedback prior to setting an offer price. To induce

investors to truthfully reveal interest, the banker designs a price/allocation rule that,

on the one hand, minimizes the benefits from downplaying interest and, on the other,

rewards investors for truthfully revealing strong demand.

The threat to cut the allocation to investors who reveal weak interest is the “stick”

with which the banker “punishes” cheating investors, and the allocation of

underpriced shares is the “carrot” offered to truth tellers. The “stick” might not be as

threatening, however, if investors who do not receive an allocation in the IPO can still

profit from their hidden (misrepresented) information through trading in the

aftermarket. In fact, the ability to trade in the aftermarket creates further incentive for

investors to misrepresent interest during the premarket, because they can cause

mispricing of the IPO and then trade in the aftermarket to exploit the mispricing. To

outweigh this additional benefit and induce truthtelling during bookbuilding, the

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“carrot” has to be larger, therefore. In other words, bookbuilding would be more

costly than previously thought if aftermarket trading were considered.

Fixed price offerings also would be more costly in this framework. Even if informed

investors can be completely excluded from IPOs -- a situation that would lead to zero

underpricing in Rock’s (1986) framework -- these investors can still trade

strategically in the aftermarket, profiting at the expense of the uninformed investors

who are allocated the IPO shares and who may have to trade in the aftermarket for

liquidity or other reasons. Several arguments that finalize the debate includes-

• Fixed price offerings require a lower discount than that needed under the

bookbuilding method as modeled in the literature. Misrepresenting

information during bookbuilding and then trading in the aftermarket generates

a higher profit on average for the informed investors than aftermarket trading

in fixed-price offerings. This is because in the first instance, informed

investors can cause and then benefit from the highest possible mispricing,

requiring the underwriter building a book to pay (through underpricing) for the

full value of investor information. In fixed price offerings, the underwriter sets

the offer price by integrating over possible investor information, and any

mispricing that remains is due to the ‘absence’ rather than the

misrepresentation of information. It is therefore cheaper for the firm to sell its

offering through the fixed price method.

• There is a strategy that makes price discovery in the premarket cheaper. If

investor pieces of information are sufficiently correlated, the banker building a

book can target a subset of the informed investors that is just enough to buy

the whole issue. The targeted investors can be induced to surrender their

information through the promise of larger allocations of slightly underpriced

shares, as the alternative for these investors if they withhold information is to

compete in the aftermarket with the rest of the informed public. If the ratio of

the targeted investors to the entire informed public is small enough,

underpricing under bookbuilding could drop below that required under fixed

price

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• And last, the SEC should review the efficiency of the bookbuilding

mechanism. Benveniste and Wilhelm (1990) show that successful

bookbuilding requires that the underwriter have discretion over share

allocations. Specifically, the banker has to be able to discriminate among

investors participating in the premarket on the basis of the indications they

give. Without such discretion, the banker cannot solicit reliable indications

and bookbuilding loses its advantage even relative to a fixed-price strategy

that suffers from the winner’s curse like in Rock (1986). The dominance of

bookbuilding can only be established if the banker has the added discretion to

limit the participation in the premarket to a select group from the informed

investors at large.

Why Price Rises in the Secondary Market?

The price increases in the secondary market because of ownership constraints in the

primary market and heterogeneous information to all investors about the stock. To

illustrate the relation between the ownership-constrained offer price and the

equilibrium secondary market price consider a simple example of a firm seeking to go

public and sell two shares (public float). Based on the information about value

provided, two investors A and B value the shares as VA and VB. The relations

between offer price (OP) and the equilibrium secondary market price (MP), and thus

initial underpricing or initial returns (IR) will depend on several conditions:

(1) If VA = V B, then OP=MP, IR=0;

(2) If VA>

< VB, and there is a wealth constraint (i.e. each investor can only

afford one share) at the initial offering and in the secondary market,

then OP=MP, IR=0;

(3) If VA>

<VB , there is no wealth constraint, and the ownership restrictions

are not binding at the offering (i.e. the investor who values the issue

the most is allowed to purchase both shares at the offering), then

OP=MP, IR=0;

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(4) If VA>

<VB, there is no wealth constraint, and ownership restrictions are

binding at the offering but are relaxed in the secondary market, then

OP<MP and IR>0.

In the first case, there is no divergence of opinion among the investors; the issue will

not be underpriced. Both the investor values the share at the same price. In case (2),

because of the wealth constraint in both the initial offering and the secondary market,

each investor can only afford one share. There is divergence of opinion, for example

VA > V B. The offer price will be set at V B to clear the market. Each investor will be

allocated one share. The investor who values the share higher (investor A) cannot

drive up the price in the secondary market because of the wealth constraint.

Therefore, OP=MP and IR=0. In case (3), wealth constraint is not binding and each

investor (A or B) can afford to buy both shares. Let say VA > V B. The offer price

will be set at VA, which is the market clearing price. The investor who values the

shares the most (investor A) will purchase both shares. Therefore, OP=MP and IR=0.

The more interesting case is case (4). Here the wealth constraint is not binding, but

there is an ownership restriction at the offering and that results in rationing. Again

assume VA > V B. Investor A is willing to buy both shares at VA, but he is rationed to

buy only one because of ownership restriction. To satisfy the ownership restriction,

i.e. to sell shares to both investors A and B, offer price has to be set at V B or below

(to entice investor B to participate in the offering). At V B or lower, both investor A

and B would like to buy 2 shares. Because they are rationed to only one share each,

they (especially investor A) will try to bid up the price in the secondary market when

the ownership restriction is relaxed, thus resulting in initial underpricing (OP<MP and

IR>0).

Investors A and B have different estimates of value because they have heterogeneous

opinions. The price of the IPOs will eventually increase in the initial trading day.

That’s why there exist underpricing. This means that initial underpricing is

unintentional and is a natural by-product of divergence of opinion and ownership

dispersion constraint.

Page 21: IPO Under Pricing

21

Again, we know the scarcity of capital is a common feature of emerging markets. The

rapid industrialization in the country required capital. As there are no attractive

investment opportunities other than fixed earning from the bank or investment in

share, the domestic institutions and households can only either deposit their money in

banks or invest in shares. The low interest rates offered depositors derived a high

demand for equity investments. The IPO pricing phenomenon is formulated as the

following chart.

P B F PF D E H PE O QE Q The demand curve of investors is BE and the supply curve of issuers is OD. In a

competitive primary market, the equilibrium of demand and supply, point E, prices

the IPO shares at E P with issuing E Q amount of shares. The demands of investors

are actually depressed at this stage, because of the asymmetric information about the

intrinsic values of IPO firms. The process of public offerings disseminates

information. After learning more about the quality of IPO firms, the demand of shares

increases and the demand curve shifts from BE to GH on the first day of trading.

Since the quantity of IPO shares cannot be changed immediately; there is a temporary

rigidity of supplies. The supply curve is OEF. On the first day of public trading, the

share price therefore increases from E P to F P. Due to the information asymmetry

between the issuer and investor, the investor demands some extra reward. This IPO

investment risk is observed worldwide, and may also induce part of the underpricing

in Bangladesh.

Page 22: IPO Under Pricing

22

The Market

The capital market in Bangladesh has a relatively recent beginning. It is gradually

evolving as an economic institution in response to the internal requirements of a

fledgling modern economy, which has emerged as a result of economic development

and industrialization efforts. Bangladesh is still a predominantly agricultural

economy. However, the industrialization process over the last three decades since

independence has diversified the economic base of the country at least to some

degree. In spite of some degree of industrialization and in spite of the fact that the

equity market has existed since 1954, it still displays features of an emerging equity

market for several reasons.

First, market capitalization is still a very small proportion of the country’s GDP.

Second, investment in stocks and shareholder participation is limited to a small

proportion of the population.

Third, domestic resource mobilization for industrialization and economic

development is still done primarily through the regular banking system. And

Finally, with increased liberalization and openness of the economy since the 1990's,

the equity market in this country has experienced some growth partly due to increased

foreign participation.

Two stock markets in Bangladesh, one is named Dhaka Stock Exchange ( DSE) in

Dhaka and another one is called Chittagong Stock Exchange ( CSE) in Chittagong

comprise of the capital market of Bangladesh. A central regulatory agency which is

the Securities and Exchange Commission (SEC) overseeing the activities of the entire

capital market including issue of capital, monitoring the issue of stocks, and operation

of the stock markets. The number of listed companies in DSE are 432 of which are

shares,8 debentures,1 corporate bond and 10 mutual funds. The listed companies in

CSE are 242 with shares, 16 mutual funds and 1 debentures.

Page 23: IPO Under Pricing

23

DSE in last 4 Years

Particulars FY05 FY06 FY07 FY08

No. of listed securities* 277 303 325 378

Issued equity and deb* (in billion) 66.4 85.7 164.3 284.4

New equity through private placement & IPOs (in billion) 1.2 1.7 3.1 7.4

Market capitalization (in billion) 224.6 225.3 491.7 964.8

Turnover in value (in billion) 75.6 46 164.7 543.3

Turnover in volume (no. in billion) 1 0.6 2 3.8

All-share price Index 1713 1339.5 1764.2 2588

Source : Dhaka Stock Exchange.

* Including companies, mutual funds, debentures and

Government Treasury Bonds.

During the period of 2005 and 2007 total number of tradable securities increased by

11.12% and the issued capital of all listed securities increased by 62.33%. In 2008

market has been affluent by 2 more mutual fund and 12 IPOs. However, both total

turnover of securities and total traded amount of securities has increased enormously

compared to that of the previous year. The total Market Capitalization of all listed

Securities in the DSE amounted to US$ 10822.36 million in 2007.

It is to be noted here that special incentives are provided to encourage nonresident

Bangladeshis to invest in the capital market. The nonresident Bangladeshis were to

enjoy facilities similar to those of the foreign investors. Moreover, they can buy

newly issued shares/debentures of Bangladeshi companies and can maintain foreign

currency deposits (styled as NFCD1 account) in special accounts for up to five years.

A quota of 10% reserved for nonresident Bangladeshis in primary shares (IPO) has

also been initiated.

Recent Developments in DSE:

Twelve companies raised new equity of Taka 7.4 billion in the primary market in

FY08, higher than the Taka 3.1 billion raised by the same number of companies in

FY07. Of the new equity issued, Taka 1.5 billion raised through private placement

and Taka 5.9 billion (of which Taka 2.4 billion was collected by three SOEs from the

capital market in direct listing opportunities) through public offerings in FY08 as

against Taka 0.04 billion raised through private placements and Taka 3.1 billion

through public offerings in FY07.

Page 24: IPO Under Pricing

24

Market condition judgement

0.00500.00

1000.001500.002000.002500.003000.003500.00

1-J

an

-20

05

1-A

pr-

20

05

1-J

ul-

200

5

1-O

ct-

20

05

1-J

an

-20

06

1-A

pr-

20

06

1-J

ul-

200

6

1-O

ct-

20

06

1-J

an

-20

07

1-A

pr-

20

07

1-J

ul-

200

7

1-O

ct-

20

07

1-J

an

-20

08

1-A

pr-

20

08

1-J

ul-

200

8

1-O

ct-

20

08

Date

Ind

ex

Index

In the sample period the market had a mixed performance. The moving average shows

that the index was decreasing up to July 2006 and then rebounded. From July 2006 to

December 2008 the market was hot. IPOs at that period had greater return. The

volume of public offerings in FY08 was predictably oversubscribed more than four

times indicating the high demand of new securities in the primary market. Bonus

shares valued at Taka 9.2 billion were issued in FY08 by seventy-one companies

against retained profits, higher than the Taka 6.8 billion issued in FY07 by fifty

companies.

Experiment Data

Variables on which the effectiveness of fixed method can be determined will be

determined with using two variables as - First-day returns and the final offering price

range for IPOs.

A. Variables

The first-day return is a percentage change in the price of a share at the end of its first

trading day from the offering price. Investors experience positive first-day returns

when they sell their shares to other investors at a higher price than what they paid the

issuer during the IPO. By implying that there are other investors in the market who

are willing to pay a higher price for the new shares, positive first day returns strongly

suggest that an issuer’s shares were under-priced, and that the issuer failed to

maximize gross proceeds received from the IPO. On the other hand, negative first day

returns may be observed if the IPO attracted fewer investors than expected. Finally,

Page 25: IPO Under Pricing

25

positive or negative first-day returns also directly measure the fluctuations in the

issuer’s share price immediately after the IPO.

Offering prices were obtained from IPO prospectuses filed by the issuer with the SEC.

First-day closing prices were obtained from the DSE database. Before investment

banks promote an IPO, they calculate an initial price for the issuer’s shares after

analyzing the issuer’s business prospects and financial position.

B. Data

The sample I analyze is some what narrow to carry out an explanation about the Short

run performance of the IPOs. I gather a sample of IPOs brought to the Dhaka Stock

Exchange between 2005 and 2008.While working at SEC I go through different IPO

files, which give data on the extent of over-subscription of issues. From prospectus I

got some information on issuer-specific characteristics prior to the IPO date. Firm

data includes book value of asset, profit, age of the firm. Issue data include the offer

data, number of share issued, amount raised, offer price, first aftermarket price and

other offering detail.

To estimate under-pricing, we need information on the stock prices of issues on their

opening day of trading. These price data are obtained from the records of the stock

exchange. the sample is dominated by a bit hot IPO tenure and strong dominance of

Banking and Insurance Sector. Of the 32 IPOs, all of the firm used the fixed pricing

and all but Barger Paints used Book value or Net asset value per share. Barger Paints

(BD) Ltd used Dividend Discount Model (DDM) in asset valuation.

Sector Representation in IPOs

53%

32%

6%

6%

3%

Bank

Insurance

Engineering

Fuel & Power

Miscellaneous

32 IPOs in the sample is basically dominated by the Banking and Insurance sector.

Only seven IPOs were from engineering, fuel and power and Miscellaneous.

Page 26: IPO Under Pricing

26

Experiment Methodology

To facilitate comparison on empirical IPO underperformance throughout the globe I

calculated the return using the methodology used by Aggarwal, Leal and Hernandez

(1993). For simplicity, I describe the methodology below.

The total return for stock ‘i’ at the end of the first trading day is calculated as:

Ri1 = (Pi1 / Pi0) − 1

Where, Pi1 is the price stock ‘i’ at the close of the first trading day, Pi 0 is the offer

price and Ri1 is the total first-day return on a stock.

The return on the market index (DSE General Index) during the same time period is:

Rm1 = (Im1 / Im0) − 1

Where Im1 is the DSE General Index value at the end of first trading day and Im0 is

the index value on the offer day of the corresponding stock, while Rm1 is the first

day’s market return.

Using these two returns, the Market Adjusted Abnormal Return (MAAR) for each

IPO on the first day of trading is computed as:

MAARi1 = 100 × {[( 1 + Ri1 ) / ( 1 + Rm1 )] − 1}

Thus the value of MAARi2, MAARi3,……MAARit for IPO ‘2,3,………N’ on the

2nd,3rd,….tth day of trading can be computed in the similar way.

This measure of the abnormal returns does not take into account the systematic risk

associated with each issue. When MAARi1 is interpreted as an abnormal return, the

assumption is that the systematic risk of the IPOs under consideration is the same as

that of the index.

I have used the DSE General Index as a market proxy rather than DSI or DSE-20 for a

valid reason that the use of DSI or DSE-20 will lead to misleading assessments of

Page 27: IPO Under Pricing

27

abnormal performance when the composition of the sample of companies under

assessment differs from the DSI and DSE-20 index criterion.

The DSE General Index measures the performance of companies other than z

category and as the new issues are fresh one and has uploaded in the market by

satisfying criterion and the index is not constrained within 20 companies, as in DSE-

20 which itself is a debate whether actually it represents Blue Chips properly. DSE

General Index Properly reflects the Bangladeshi Equity Market.

Performance measurement for a group of IPOs is assessed by the wealth relative,

which is defined as:

WR1 = [1 + 1/N RiN ] / [1 + 1/N RiN]

Where WR1 is the Wealth Relative for the first day’s trading and N is the total number

of IPOs in the sample. A wealth relative above one (1<WR1) implies that the IPOs

outperformed the market in that period. A wealth relative below one (1>WR1)

indicates underperformance.

The sample Mean of Market Adjusted Abnormal Return for the first trading day,

MAARi1, may be viewed as a performance index which reflects the return, in excess

of the market return, on a Taka of investment divided equally among N new issues in

a sample:

MAARi1 = 1/N MAARiN

To test the hypothesis that MAAR i1 equals zero, I computed the associated Z statistic:

Z = [MAARi1] / SD] / [SQRT(N)]

Where SD is the standard deviation of MAARi1. If underpricing of new issues exists,

one would expect a positive value of the MAARi1.

Page 28: IPO Under Pricing

28

Aggregation of daily abnormal returns

Commonly used IPO event study methodology is followed to calculate abnormal

returns and test for significance. Cumulative excess returns are examined over a 1-

month period following the date the security is listed on the Dhaka Stock Exchange.

The DSE General Index serves as a proxy for the market returns.

The following three equations describe the process for computing excess returns (xr),

average excess returns (AXR), and cumulative excess returns (CXR). First, the excess

return for each security i on day t (xri,t) is computed as the difference between the

return of the security on day t (ri,t ) and the return of the market index on day t (rm,t).

For computing monthly excess returns, t represents the respective month.

xrit= rit-rmt

Next, the average excess return for the sample for each month t (AXRt) is derived

from the mean of the sum of the excess returns of each of the n securities during

month t.

AXRt= (1/N)Σ xrit

Finally, cumulative excess returns as of month T are computed as the summation of

the average excess returns starting at month 1 until month T.

CXRit= Σ AXRt

P-values for monthly average excess returns (AXR) and the cumulative average

excess returns (CXR) are calculated and tested using a Z-score to determine

significance at the .10 alpha level. The respective p-values for these tests are given in

the Tables 1 and 2. Cumulative abnormal returns are tested for each month to

determine whether the foreign equity is yielding a greater return than DSE General

Index. A p-value of .10 or less indicates the abnormal return or cumulative abnormal

return is significantly different from 0. The p-value is derived from the Z score:

Z Test = 1 – Normal Distribution [(X-Uo)/S/square root N)]

Page 29: IPO Under Pricing

29

where: X is the sample mean; Uo = 0 to test that the average is different from 0; S is

the sample standard deviation; N is the number of monthly returns in the sample; The

normal distribution of the z-score tells the probability that X is not equal to zero.

Therefore, a p-value of .10 indicates that there is a 90 percent probability that the

foreign equity return differs from the DSE General Index return. Calculations are

performed through Microsoft Excel.

Regression Analysis

In this section linear regressions are used to investigate the determinants of

underpricing of the initial public offerings on the DSE. The explanatory variables are

selected on the basis of previous empirical work, with emphasis on testing the

signaling hypothesis. The initial regression model investigated is the following:

Raw Return = βo

+ β1log Issue_Size + β

2 log Total_Asset + β

3 log Net_Profit + β

4 log

Age_Firm + β5 Risk+ β

6 Market_Return.

Page 30: IPO Under Pricing

30

Results of Experiment

I will now apply the methodology outlined above to assess the returns on the IPOs in

my sample. I compute WRt, MAARit, and the associated t statistic. I will look for

what is the Market adjusted Abnormal Return on the First Trading Day of the stock

and also the Month level Mispricing. After analyzing the underpricing phenomenon I

will check the Short Run Performance of IPOs in DSE. With Regression analysis, the

determinants of the Initial return will be pointed out.

Sample 32

Underpriced 29

Overpriced 3

The average returns on the first day of trading are 221.38 percent for the entire

sample.the result is statistically significant (p=.4247).

Return by Issue sige

239.16

209.27

209.13

190 200 210 220 230 240 250

small

medium

large

Sig

e o

f is

su

e

Return (%)

return (%)

Of the 32 IPOs in the sample only 3 were overpriced. If segmented by the issue size

then Large and medium issue emerges with the same return like 209 % but on the

other hand small issue has a return has 239.16%. Small issues suffer from larger

underpricing. The total sample was assessed by small (<100 million; n=13), medium

(100<500 million; n=13) and large issue (>500 million; n=6) variant. So the return

does not differ immensely if analyzed issue wise. The empirical results here

contradict the theory that the large issues will have relatively high return to agitate the

investors to absorb large issue.

Page 31: IPO Under Pricing

31

Return by Underwriters Prestige

217.99

222.71

214 216 218 220 222 224

low prestige

high prestige

Pre

stige

Return (%)

return (%)

The prestige was determined by two Reputational Variable (URV1 and URV2)

measured by no of total issue and percentage of total issue underwritten by a specific

investment bank. Segmented by the underwriter’s prestige the return is almost same

some where near 220%.This means the investment banks here in Bangladesh does not

have that much influence in the initial return.

Return by Market Condition

247.13

183.76

0.00 50.00 100.00 150.00 200.00 250.00 300.00

Cool

Hot

Mark

et C

onditio

n

Return (%)

Return (%)

Market has significant impact on the MAAR and in the hot market (July 2006 to

December 2008) the return was 247.13% while in cool market (before July 2006) it is

183.76%.

Yearwise IPO Return

357.84

225.20

117.96

282.61

0.00 100.00 200.00 300.00 400.00

2008

2007

2006

2005

Year

Return

Page 32: IPO Under Pricing

32

Return on IPOs in 2006 was a bit slacking after 282.61% in 2005. In 2008 the overall

market was in upward trend and IPOs at that period experienced 357.84% return on

an average.

Losers & Winners

-100.00

0.00

100.00

200.00

300.00

400.00

500.00

600.00

700.00

800.00

900.00

SA

PO

RT

LF

IRS

TS

BA

NK

DB

HC

ON

TIN

INS

FID

EL

AS

SE

TC

ITY

GE

NIN

SP

AR

AM

OU

NT

TR

US

TB

AN

KIL

FS

LP

HO

EN

IXF

INU

NIO

NC

AP

PR

EM

IER

BA

NG

OL

DE

NS

ON

SH

AH

JA

BA

NK

BR

AC

BA

NK

IPD

CP

RIM

EL

IFE

BIF

CL

AN

KA

BA

FIN

SA

LA

MC

RS

TJ

AM

UN

AB

AN

KP

RA

GA

TIL

IF B

ER

GE

RP

BL

PR

OG

RE

SL

IFIS

LA

MIC

FIN

SO

NA

RB

AIN

SA

SIA

PA

CIN

SP

RE

MIE

RL

EA

SU

MIT

PO

WE

RP

RIM

EF

INN

ITO

LIN

SM

EG

HN

AL

IFE

IPOs

Re

turn

MAAR %

The winners and losers of this exercise are exhibited in the charts above. Amongst the

32 sample SAPORTL has significant mispricing with a first day return 781.49% this

is the maximum in the sample. The sample has a mean return of 222.61% in the 1st

trading day. The offering was underwritten by Alliance Financial Services Limited

(AFSL). ASIAPACINS is found overpriced with a negative return of -40.90%.

Wealth Relative (WR) 3.216

Wealth Relative (WR) is 3.216 means that the sample IPOs has outperformed the

market 300 times in the First day of trading.

Panel A: Descriptive Statistics for

the 32 IPOs

Variable Mean Minimum 25th 50th 75th Maximum

Standard

Deviation

Offer price (OP) 108.28 10.00 100.00 100.00 100.00 225.00 47.39

First day market price 369.84 19.20 161.25 307.25 453.50 1550.00 338.12

Proceeds, millions 2657.79 91.50 354.56 1174.68 3749.65 17806.30 3605.08

Earnings per share 22.50 0.60 7.89 15.10 39.32 67.37 20.09

Preissue book value/share 148.07 10.22 110.53 136.44 163.08 402.52 76.77

P/E (OP/EPS) 14.44 1.48 3.56 6.51 10.66 119.05 25.71

M/Bpre(MV/BPSpreissue) 2.48 0.47 1.42 2.11 2.99 7.24 1.68

Page 33: IPO Under Pricing

33

Panel A reports some descriptive statistics on firm specific and market related

characteristics. The sample suffers from significant underpricing on an average.

ILFSL had a 225 taka offer price while the offer price ranges from 10-225 taka. First

day market price was thundering 1550.00 taka for DBH. ASIAPACINS on the

other hand was overpriced and this 100 taka face value share had a 59.25 taka closing

price at the end of the first day. P/E (OP/EPS) was maximum 119.05 with a variability

of 25.71.

P/E Comparison

0.00

50.00

100.00

150.00

200.00

250.00

300.00

350.00

400.00

450.00

500.00

SAPO

RTL

FIR

STSBAN

K

DBH

CO

NTIN

INS

FID

ELASSET

CIT

YG

EN

INS

PAR

AM

OU

NT

TR

USTBAN

K

ILFSL

PH

OEN

IXFIN

UN

ION

CAP

PR

EM

IER

BAN

GO

LD

EN

SO

N

SH

AH

JABAN

K

BR

AC

BAN

K

IPD

C

PR

IMELIF

E

BIF

C

LAN

KABAFIN

SALAM

CR

ST

JAM

UN

ABAN

K

PR

AG

ATIL

IF

BER

GER

PBL

PR

OG

RESLIF

ISLAM

ICFIN

SO

NAR

BAIN

S

ASIA

PAC

INS

PR

EM

IER

LEA

SU

MIT

PO

WER

PR

IMEFIN

NIT

OLIN

S

MEG

HN

ALIF

E

IPOs

P/E

IPO Pricing Multiplier Secondary Market P/E

Secondary market P/E multiple is significantly higher than that of offering price

earnings and the graph shows that the multiple became five fold higher in case of

Prime life insurance and Progressive life insurance. The earnings of life insurance

firm in the sample were based on the prospectus and assessed by the actuary there on.

Page 34: IPO Under Pricing

34

Daily After Market Return

95.00

96.00

97.00

98.00

99.00

100.00

101.00

102.00

103.00

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29

Days

Re

turn

After floatation of the share the return in the subsequent period up to 30 days varied

from -03.40 to 3.002%. The fluctuation even though had a negative trend.

Cumulative Holding Period Return

84.00

86.00

88.00

90.00

92.00

94.00

96.00

98.00

100.00

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

Return

Da

ys

In graph above data indicate that the 30 days cumulative excess returns for the IPOs

in the sample is a -10.22%. Therefore, findings indicate that investments in the IPOs

for a 30 day period by taking a long position at the 1st day tend to perform poorer than

the market as a whole.

Page 35: IPO Under Pricing

35

Determinants Attribution

Here is the determinant factors that are expected to have in effect on the IPO returns.

In order to test the different characteristics on the underpricing level some issue

related characteristics, issuer related characteristics and market related characteristics

have been identified as dependent variable. The initial return has been regressed

against these variables. To avoid co linearity with the market variable, MAAR has not

been used as market return is a functional variable in the model.

Descriptive Statistics

N Minimum Maximum Mean

Std.

Deviation Return at Day 1 32 -40.90 781.49 222.61 209.09

Issue Size (mn) 32 45 1150 268.28 310.750

Age of the Firm 32 2 33 8.72 6.012

Total Asset (mn) 32 74.22 46382.59 5928.15 10605.53

Net Profit (mn) 32 .256 7989.00 341.88 1401.14

sponsor's share holdings (thou) 32 147 260000 12360.78 45538.49

Market Return 32 -.0049 .0067 .00127 .0024

Risk 32 .722 123.37 25.38 28.76 Valid N (listwise) 32

Amongst the 32 sample First day return is maximum 781.49% (SAPORTL) with a

mean of 222.61%. ASIAPACINS is found overpriced with a negative return of -

40.90%. The sample include relatively juvenile firm in the industry SALAMCRST

having only 2 years of business experience and on the other hand experienced

one like BERGERPBL. All of the firms are doing good business and profit making is

a continuous. LANKABAFIN has largest sponsors holdings (260 million). With a

mean of 1.27% last 30 days before the issue on an average the market has a -4.9% to

6.70% return range. The return is extremely volatile with a variability of 2.4%. The

return of the issue in the 30 days window shows much volatility.

Page 36: IPO Under Pricing

36

Correlations

Pearson Correlation

Return

at Day

1

Issue

Size

(mn)

Age

of the

Firm

Total

Asset

(mn)

Net

Profit

(mn)

sponsor's

share

holdings

(thou)

Market

Return Risk Return at Day 1 1.000 -.047 -.156 .120 .147 -.109 .306 .871

Issue Size (mn) -.047 1.000 -.097 .662 -.103 -.076 .031 .008

Age of the Firm -.156 -.097 1.000 -.097 -.033 .057 -.017 -.127

Total Asset (mn) .120 .662 -.097 1.000 -.030 -.035 .254 .215

Net Profit (mn) .147 -.103 -.033 -.030 1.000 -.054 -.074 .018

sponsor' share holdings (thou) -.109 -.076 .057 -.035 -.054 1.000 -.142 -.171

Market Return .306 .031 -.017 .254 -.074 -.142 1.000 .200

Risk .871 .008 -.127 .215 .018 -.171 .200 1.000

Sig. (1-tailed)

Return at Day 1 . .399 .196 .257 .210 .276 .044 .000

Issue Size (mn) .399 . .299 .000 .288 .340 .434 .482

Age of the Firm .196 .299 . .299 .428 .377 .463 .244

Total Asset (mn) .257 .000 .299 . .436 .425 .081 .119

Net Profit (mn) .210 .288 .428 .436 . .385 .344 .461

sponsor's share holdings (thou)

.276 .340 .377 .425 .385 . .220 .174

Market Return .044 .434 .463 .081 .344 .220 . .136

Risk .000 .482 .244 .119 .461 .174 .136 .

N 32 32 32 32 32 32 32 32

First day return has a statistically significant correlation with the return variability of

the issued securities. This means that the risk of the security requires extra reward in

the form of price increment and thus with positive return.

The First day return is negatively correlated with Issue Size (mn), Age of the Firm

and sponsor's share holdings (thou) and positively related with Total Asset (mn),

Net Profit (mn), Market Return and Risk of the issue. Return depends based on the

hot or cool market issue. That is when the market return is positive the issued security

has positive return. This is because the investors believe that the price momentum of

the market will remain same in the neat future.

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37

Model Summary(b)

Mode

l

R

R2

Adj.

R2

Std.

Error of

Estimate

Change Statistics Durbin-

Watson

1

R2

Change

F

Change df1 df2

Sig. F

Change .903 a .815 .761 102.141 .815 15.129 7 24 .000 2.374

a Predictors: (Constant), Risk, Issue Size (mn), Net Profit (mn), Age of the Firm, sponsor's share holdings (thou), Market Return, Total Asset (mn) b Dependent Variable: Return at Day 1

In summary above, First day return is predicted from Issue Size (mn), Age of the Firm

and sponsor's share holdings (thou), Total Asset (mn), Net Profit (mn), Market Return

and Risk of the issue. This output shows all independent variables here together

explain 76.10% of the variance in return for this sample. R2 change is the same as R2

because the variables were entered at the same time (not stepwise or in blocks), so

there is only one regression model to report. Since there is only one model, "Sig F

Change" is the overall significance of the model, which for one model is also the

significance of adding the explaining variables to the model in addition to the

intercept. In my sample the F- Statistic is significant, means the variable deemed to

explain the initial return has a significant impact. As Durbin-Watson statistic is 2.374

that’s why I reject the data are autocorrelated (serially dependent) and the

observations are independent.

ANOVA(b)

Model

Sum of

Squares df

Mean

Square F Sig.

1

Regression 1104912.67 7 157844.66 15.129

.000(a) Residual 250390.02 24 10432.91

Total 1355302.70 31

a Predictors: (Constant), Risk, Issue Size (mn), Net Profit (mn), Age of the Firm, sponsor's hare holdings (thou), Market Return, Total Asset (mn) b Dependent Variable: Return at Day 1

The F-Statistic in the ANOVA table is same as the MODEL SUMMARY and significant at .000 level.

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38

Coefficients(a)

Unstandardized

Coefficients

Standardized

Coefficients

t

Sig.

95% Confidence

Interval for B

B Std.

Error Beta Lower Bound

Upper Bound

(Constant) 52.582 44.896 1.171 .253 -40.078 145.242

Issue Size (mn) .037 .083 .055 .445 .660 -.134 .208

Age of the Firm

-1.784 3.095 -.051 -.577 .570 -8.172 4.604

Total Asset (mn)

-.003 .003 -.149 -1.164 .256 -.008 .002

Net Profit (mn) .022 .013 .149 1.676 .107 -.005 .050

sponsor's share holdings (thou) .000 .000 .076 .839 .409 -.001 .001

Market Return 16442.7 8221.32 .189 2.000 .057 -525.27 33410.6

Risk 6.313 .684 .868 9.234 .000 4.902 7.724

a Dependent Variable: Return at Day 1

The risk of the IPOs issued is significant and a good predictor of the IPOs first day

return. Market return and net profit have relatively high importance in explaining the

variation in the return.

In the Confidence Intervals section we see that 0 is between the upper and lower

bounds for the b coefficient for Issue Size (mn), Age of the Firm and sponsor's share

holdings (thou), Total Asset (mn), Net Profit (mn) and Market Return, meaning that

the coefficient for these variables cannot be assumed at the 95% confidence level to

be different from 0 (this is a different way of saying age is not significant). Because

Risk of the issue is significant, 0 is not within its upper and lower confidence bounds.

The zero-order and partial correlations for Risk are almost same because when I

control the zero-order correlation of Risk with Return for Issue Size (mn), Age of the

Firm and sponsor's share holdings (thou), Total Asset (mn), Net Profit(mn) and

Market Return , these has very little influence.

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39

Explanation

This is evident from the fact that both underpricing is affected by publicly available

information known prior to the IPO. The following are the variables that are likely to

affect the IPO excess return and the demand for IPO units.

Investment Risks:

IPO underpricing is a universal phenomenon. There was 111.58 percent money “left

on the table” in my sample. The theory of asymmetric information is thus far the most

accepted underpricing rationale. It argues that the investors are afraid of the winners’

curse (Rock 1986) or a negative information cascade (Welch 1992). IPO subscribers’

worries mean that there are significant investment risks in the primary market. The

IPO-specific investment risks depress the demand of investors, which is relieved after

flotation. This provides a theoretical foundation for the shift of demand curves from

BE to GH in my framework. This shift of IPO demand curves and the consequent

change of equilibrium prices are observed in the Bangladesh primary market.

The hypotheses may not cover all of the risks in Bangladesh primary markets, but

they can provide a good test of the demand shift from BE to GH described in the chart

above.

Informational Risk:

Beatty and Rock (1986) argue that the expected underpricing is an increasing function

of uncertainty. IPO underpricing of a better-known firm is lower, since a larger firm is

usually better known than a smaller one. A firm with a longer history is also better

known than one with a shorter history.

These observations lead to our first two hypotheses.

Hypothesis 1.1: Initial returns of IPOs are a negative function of corporate size;

Observed phenomenon: the corporate size explains -14.9% of the initial return and the

coefficient of the logarithm of corporate assets is significant at .256 level. The

underpricing is higher in smaller sized firm and vice versa. Thus the hypothesis is

supported.

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40

Hypothesis 1.2: Initial returns of IPOs are a negative function of corporate history.

Observed phenomenon: The year of business parameter explains -5.1% of initial

return. A firm with a longer corporate history should also be relatively better known

and therefore it is less underpriced.

Managerial risk:

McConnell and Servaes (1990) show that, up to a certain point, corporate value

increases with insider ownership. When a firm has high inside ownership, insiders

should be reluctant to underprice the firm’s IPO shares.

Hypothesis 1.3: The size of insider ownership is negatively related to initial returns.

Observed phenomenon: 7.6% is explained by the sponsor’s shareholdings. There is

significant relation between initial returns and the sizes of managerial shareholdings.

Issue size:

Larger IPOs generally more underpriced, perhaps to enable traders absorb the larger

quantity of securities.

Hypothesis 1.4: the offer size is positively related to initial returns.

Observed phenomenon: Result is found contrary here. The smaller IPOs found to

have greater underpriced. The underpricing of IPOs was greater than was necessary to

attract a sufficient level of demand.

Risk of the issue:

It is the standard deviation of daily excess return over 30 days after the IPO. Theory

predicts a positive relationship between underpricing and uncertainty. Rock (1986, p.

189) stated: “the greater the uncertainty about the true price of the new shares, the

greater the advantage of the informed investors and the deeper the discount the firm

must offer to entice uninformed investors into the market.” Welch (1992) proposed

that underpricing is an increasing function of a mean-preserving increase in the spread

of investors’ prior beliefs about the IPO price. In addition, risk-averse underwriters

with firm commitment to absorb the quantity that is unsold at the IPO price may

underprice the issue to reduce their risk. Indeed, empirical evidence shows that

underpricing rises with price uncertainty (Ritter (1984)).

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41

Greater uncertainty about the issued securities led to greater underpricing as well as

greater excess demand, which resulted in smaller allocation. That is, the greater

underpricing of riskier IPOs did not necessarily provide greater risk premiums to their

buyers. The result here is consistent with the suggestion that riskier IPOs are priced

lower to protect the interests of risk-averse underwriters.

Oversubscription Rate:

Under the offering quotas, investors in the primary market are not assured of getting

the shares they subscribe to. The underwriters allocate shares by lotteries, and the

lottery success rate of IPO applications reflects the interaction of controlled supplies

and depressed demands in the primary market.

Over Subscriptions Times

Over Subscriptions Times FY04 FY05 FY06 FY07 -Value (Tk. mn) 13.15 12.48 10.62 8.18

Depressed demand in Dhaka Stock Exchange is somewhat responsible for the higher

aftermarket return.

Financial Regulations

The financial regulations of the fixed-pricing method and too much dependence on

accounting numbers while determining the offering price bring about extraordinary

IPO underpricing in Bangladesh. Discounted Cash Flow (DCF) better reflects firms

potential in terms of growth and future prospect. As investors are paying today and

thus hold long position based on future value of the share, thus the present value of

the future cash flows are very much relevant and should be judged before determining

the price. Again Book building method can lower the underpricing because the

investors demand can be better reflected in BBM. Till now Bangladesh has not

adopted BBM (adoption process is ongoing) and thus the price offered is not that

much efficient. In Bangladesh underpricing is severe to induce primary stock holders

to secondary market. This is a rationale why equities here are underpriced.

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Towards pricing efficiency

Present IPO Pricing Mechanism in Bangladesh:

Fixed Price- price set by the issuer and issue manager at which all the shares are

issued.

Auction – Price is determined from the bids received in sealed envelope.

Book Building- IPO offering price is determined based on demand from

institutionalinvestors.

Determination of Offering Price:

� If ordinary shares are being offered, the factors considered in determining

the offering price shall be set forth in the prospectus.

� If the issue price of the ordinary share is higher than the par value thereof,

justification of the premium should be stated with reference to-

(i) Net asset value per share at historical or current costs;

(ii) Earning-based-value per share calculated on the basis of weighted

average of net profit after tax for immediately preceding five years or

such shorter period during which the issuer was in commercial

operation;

(iii) Projected earnings per share/book value for the next three accounting

year as per the issuers own assessment duly certified by the auditor of

the issuer;

(iv) Average market price per share of similar stock for the last six months

immediately prior to the offer for common stocks or if issuance is the

repeat public offering market price per share of common stock of the

issuer for the aforesaid period; and

(v) All other factors with justification which have been taken into account

by the issuer for fixing the premium: Provided that premium on public

offering shall not exceed the amount of premium charged on shares

issued within immediately preceding one year.

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43

Determination of Offering Price and Distribution of Shares under fixed method:

� Issuer and issue manager fix price;

� All the shares are issued at same price;

� 10% shares are reserved for Non-resident Bangladeshi

� 10% shares are reserved for Mutual Funds

� If oversubscribed allocated holding lottery

The Securities and Exchange Commission is adopting new methods of pricing the

IPOs. The Book Building method is under consideration and draft has already been

prepared. The Book Building will bring more pricing efficiency. There will be a

balance between the demand for and supply of the security since book-built price will

be close to the market price.

Book Building: a new era

Security and Exchange Commission is working to introduce Book Building in

Bangladesh. SEC Consultative Committee [CC] has already prepared a draft; Draft

was presented before SEC Advisory Committee on 12 Dec. 2007. Draft rules was

approved by the Commission on its 298th Meeting held on 02 December 2008 for

obtaining comments. Presentation has been made for the stakeholders on 17 February

2008 and 14 September 2008 organized by DSE and CSE. Presentation was made for

honorable Finance Advisor on 26 Nov. 2008 where, among others, Ministry of

Finance, Bangladesh Bank and Stock Exchanges were presented. Comments are being

reviewed for incorporation in the final draft.

Eligibility for Offering Shares under Book Building Method:

[a] The company must have at least Tk. 300 million net-worth;

[b] Shall offer at least 10% shares of paid up capital (including intended offer)

or Tk. 300 million whichever is higher;

[c] Shall be in commercial operation for at least immediate past five years;

[d] Shall have profit in three years out of the immediate last five completed

accounting/financial year;

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44

[e] Shall have no accumulated loss at the time of application;

[f] Shall audit at least its latest financial statements by a firm of chartered

accountants from the panel of auditors of the Commission;

[g] Shall be regular in holding annual general meeting;

[h] The Commission if deems appropriate for the interest of investor or

development of capital market, may exempt or relax any of the above

requirements.

Draft of Procedures of Book Building Method for Bangladesh Capital Market :

The Book Building Process will have two stages:

� Price Discovery and Book Building by eligible institutional investors;

� Public offer based on price found out through Book Building Process.

Stage I:

Price Discovery and Book Building by eligible institutional investors:

• Issuer shall invite for indicative price offer from the eligible institutional

investor through proper disclosure, presentations, documents, seminars and

road shows;

• Draft prospectus shall contain indicative price based on price indications

obtained from at least five eligible institutional investors covering at least

three different categories of investors;

• Issuer shall disclose in the prospectus detail about the qualitative and

quantitative factors justifying the indicative price.

Eligible Institutional Investors:

[a] Merchant Bankers excepting the issue manager and underwriter to the

proposed issue;

[b] Foreign Institutional Investors registered with the Commission;

[c] Recognized Pension Funds and Provident Funds;

[d] Financial Institutions under regulatory authority of Bangladesh Bank;

[e] Insurance Companies regulated under Insurance Ordinance, 2008;

[f] Institutional venture capital and Institutional investors registered with the

Commission;

[g] Any other person permitted by the Commission for this purpose.

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Book Building Method for IPO Pricing:

� The indicative price shall be the basis for formal price building with an

upward and downward band of 20% of indicative price;

� Institutional investors shall bid within the price band;

� If institutional quota is not cleared within the price band the issue would be

considered cancelled unless the floor price is further lowered within the face

value of security with the approval of the Commission;

� Bidding shall commence after getting consent from the Commission;

� No institutional investor shall be allowed to quote for more than 10% of the

total security offered for sale;

� The bidding will be handled through an uniform and integrated automated

system of the stock exchanges;

� The volume and value of bid at different prices will be displayed on the

monitor without identifying the bidder;

� The institutional bidders will be allotted shares on pro-rata basis at the

weighted average price of the bids that would exhaust the total number of

securities being issued to them;

Payment Mechanism of Institutional Investor:

� Institutional bidders shall deposit 20% of the amount of bid in advance to

the designated bank account; and

� the rest 80% shall be deposited within 5 [five] working days prior to the

date of opening subscription for general public.

� In case of failure to deposit remaining amount 50% of bid money

deposited by them shall be forfeited by the Commission;

� There shall be a lock-in of 15 [Fifteen] trading days from the first trading

day on the security issued to the eligible institutional investor.

Stage II

Public offer based on price found out through Book Building Process:

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Mechanism of distribution of Shares to General Public:

� General Investor, mutual funds and NRBs shall buy at the cut-off price as

was found out through book building process through Stage I;

� Cut- off price means the lowest price offered by the bidders at which the

total issue is exhausted.

� Issuer may issue share at below cut off price to general investor with the

approval of the Commission;

� General investor will apply through banker to the issue and in case of over

subscription distribution will be made through lottery.

Distribution Mechanism of Shares: Size of Total Issue Eligible

Institutional

Investors’ Portion

General Public

Mutual Fund

Portion NRB Portion

Tk. 30 to Tk. 50 Crore 20% 10% 10% 60% or balance amount

Over 50 Crore to Tk. 100 Crore

30% 10% 10% 50% or balance amount

Over Tk. 100 Cr. to Tk. 500 Crore

40% 10% 10% 40% or balance amount

Over Tk. 500 Crore 50% 10% 10% 30% or balance amount

Probable Impact of Book Building Method on Bangladeshi Capital Market:

Positive Impacts

� Good issuers would be encouraged to raise fund from capital market;

� Difference between issue price and first day trading price will be narrowed

down;

� Tendency for opening fake BO accounts will be reduced;

� There will be a balance between the demand for and supply of the security

since book-built price will be close to the market price.

Probable Negative Impacts

� Institutional Investors may tend to bid higher price disregarding

fundamentals of the company in bullish market and lower price in the

bearish market;

� Retail investors may be disinclined to buy security at higher price of the

issue;

� Shares may be issued at price which is more than the real value of

underlying assets.

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FCF inclusion in Fixed Price method is a growing demand:

Book value – variously called shareholder equity and net worth – is broadly defined

as total assets minus total liabilities. This difference is the excess value a business has

generated in its life. Hence, book value measures only what a business has done, and

does not necessarily have bearing on what it will do. Net book value is the value of a

firm’s equity as seen through the eyes of an accountant. In mature companies and

industries, past history is often a strong indicator of future performance; in such

situations, book value is an effective tool for determining a company’s present value.

Net book value and other accounting-based valuation methods should be used only

when no other information is available. Because these methods are based on historical

cost data, they have little relation to current fair market value. Assets can be worth

more or less than their historical cost depending on inflation, obsolescence,

accounting methods, or a host of other reasons. In addition, the book value of debt

does not consider the market reaction to changing interest rates, debt markets, or the

current credit quality of the company.

Some times value is determined using multiples. This value is generally determined

by examining multiples ascribed to similar companies or by examining a “standard”

long term business model of a company or industry.

In both case, owing to its unique evolution and young age, many firms do not have a

long business history or a set of comparable companies from which to draw from. A

long term “standard” business model for the company is also difficult to ascertain; at

this stage, no one knows if a 2% return on assets, a 20% return on sales, or a 15%

return on net portfolio outstanding is appropriate. Without either tool, determining the

appropriate multiples is impossible. The situation is further complicated by the

differences between firms. Due to the youth of the industry, a plethora of models

continues to persist. Each model has different operating profiles, different profit

potentials, and carries different risk.

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48

A few perfectly legitimate accounting adjustments can tweak earnings to

management's delight, but at the end of the day, it's the cash that's left over that count.

Businesses that produce healthy amounts of free cash flow can be valued with a

higher degree of certainty and margin of safety than simply going on profits.

An effective approach must both be forward looking and function in an embryonic

industry. A valuation approach that meets these requirements is the discounted cash

flow (DCF) valuation.

Free Cash Flows are defined as cash flows that remain after we subtract from

expected revenues any expected operating costs and the capital expenditures

necessary to sustain, and hopefully improve, the cash flows. The Free Cash Flows to

Equity (FCFE) represent the free cash available to the equity holder of the company

and is good measure of the company’s capacity to pay dividends and provide capital

gains opportunity to its equity investors. Discounted FCFE, is therefore, is appropriate

way to value equity of a company which is in its initial life cycle stage, does not trade

in public and so far has not paid dividends like most Listed companies.

However FCF, or cash flow from operations less capital expenditures, can't be

manipulated through accounting changes. Remember that the value of any business is

the present value of the future cash flows of the business.

The analyst must look accurately far into the future. Discounted cash flows are

commonly used when a project is too unique for comparison or there are no existing

cash flows to which it can be compared.

A special case of the DCF method is the expected value method, where you run

multiple possible scenarios and then multiply each discounted value by the probability

of its scenario occurring. This provides an expected or “risked” value.

The scenarios and probabilities must include all possible outcomes (in other words,

the sum of all of the probabilities must equal 1) Expected value has most of the

drawbacks of the DCF method, but it allows some risks (those considered explicitly

by mutually exclusive scenarios) to be addressed more directly. It is useful in

situations where a discrete number of possible outcomes have widely differing cash

flows.

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Conclusion

Regulators are interested in mechanisms that facilitate better functioning IPO markets.

Bangladesh has a relatively juvenile capital market with low correlation with

developed markets in the advanced countries. That’s why the market has a history of

uninterrupted operations even across the financial turmoil around the world as of late.

Historically, the only alternative available for a firm contemplating a public issue was

to make a fixed price offering. The firm going public would set a price and open the

issue for subscription. Allocations were made on a strictly proportionate basis. Until

recently, issuers and investment banks had no pricing flexibility because issue prices

were effectively constrained to accounting par value or the accounting book value of

equity.

Recently Securities and Exchange Commission is going to introduce book building

method to make the pricing more efficient. In principle, book-building can alter the

incentives of both investors and investment banks participating in the IPO process.

These changes can be positive or negative. Discretion in allocation gives investment

banks greater credibility in extracting information because it offers investors the

incentive to engage in more aggressive information gathering prior to an issue. On the

other hand, discretion can also offer opportunities for abuse. Investment banks may

use the flexibility in allocation to dispense favors especially in a market like Banglade

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61

Sample judgment

Coefficients(a)

Zero-order Partial Part Tolerance VIF

(Constant)

Issue Size (mn) -.047 .090 .039 .509 1.965

Age of the Firm -.156 -.117 -.051 .972 1.029

Total Asset (mn) .120 -.231 -.102 .471 2.122

Net Profit (mn) .147 .324 .147 .971 1.030

sponsor's share holdings (thou) -.109 .169 .074 .936 1.068

Market Return .306 .378 .175 .863 1.159

Risk .871 .883 .810 .871 1.149

Part (semi-partial) correlation for Risk is the same as the zero-order correlation and

little lower than the partial correlation because the remaining variables has very little

control. Tolerance and VIF are tests for multicollinearity (overly high correlation

among the independents), which is zero problem here because VIF is surrounding

between 1 and 2 where the common rule of thumb that only VIF>4.0 indicates a

multicollinearity problem.

Coefficient Correlations(a)

Risk

Issue

Size

(mn)

Net

Profit

(mn)

Age of

the

Firm

sponsor's

share

holdings

(thou)

Market

Return

Total

Asset

(mn)

Correlations Risk 1.000 .180 .001 .113 .163 -.099 -.242

Issue Size (mn) .180 1.000 .133 .062 .133 .190 -.691

Net Profit (mn) .001 .133 1.000 .038 .076 .102 -.079

Age of the Firm

.113 .062 .038 1.000 -.029 -.015 .013

sponsor's share holdings (thou) .163 .133 .076 -.029 1.000 .142 -.113

Market Return -.099 .190 .102 -.015 .142 1.000 -.288

Total Asset (mn)

-.242 -.691 -.079 .013 -.113 -.288 1.000

Covariances Risk .467 .010 .000 .240 .000 -557.672 .000

Issue Size (mn) .010 .007 .000 .016 .000 129.155 .000

Net Profit (mn) .000 .000 .000 .002 .000 11.175 .000

Age of the Firm

.240 .016 .002 9.57 .000 -374.482 .000

sponsor's share holdings (thou) .000 .000 .000 .000 .000 .484 .000

Market Return -557.6 129.155 11.175 -374.48 .484

67590239.905

-5.970

Total Asset (mn)

.000 .000 .000 .000 .000 -5.970 .000

a Dependent Variable: Return at Day 1

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62

Rule of thumb that multicollinearity exists if a correlation is > .90 or several are >.7

in the correlation matrix formed by all the independents is judged and the correlation

is not suffering from multicollinearity.

Collinearity Diagnostics(a)

Model Dimension

Eigen

value

Condition

Index

1 1 3.706 1.000

2 1.080 1.852

3 1.006 1.919

4 .795 2.160

5 .616 2.452

6 .483 2.769

7 .210 4.199

8 .104 5.977

a Dependent Variable: Return at Day 1

Model Variance Proportions

(Constant)

Issue

Size

(mn)

Age

of the

Firm

Total

Asset

(mn)

Net

Profit

(mn)

sponsor'

s share

holdings

(thou)

Marke

t

Return Risk

1 .01 .01 .01 .01 .00 .00 .02 .02

.00 .01 .02 .03 .08 .46 .06 .01

.00 .01 .00 .01 .64 .17 .00 .01

.00 .08 .03 .11 .13 .00 .20 .04

.02 .01 .08 .03 .10 .24 .48 .01

.00 .02 .10 .00 .01 .06 .12 .68

.05 .45 .32 .60 .00 .01 .06 .00

.91 .40 .44 .19 .04 .05 .06 .23

I used Condition indices to flag excessive collinearity in the data. A condition index

over 30 suggests serious collinearity problems and an index over 15 indicates possible

collinearity problems.

My sample’s Condition Index ranges from 5.977 to 1.000 and no collinearity problem

exists. The variables does not have high linear dependence and multicollinearity, with

the effect that small data changes or arithmetic errors does not translate into very large

changes or errors in the regression analysis.

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63

The figure above confirms that this example has no collinearity problem since no

condition index approaches 30, making it unnecessary to examine variance

proportions.

Residuals Statistics(a)

Minimum Maximum Mean

Std.

Deviation N

Predicted Value 54.34 863.17 222.61 188.79 32

Residual -140.24 230.401 .000 89.87 32

Std. Predicted Value -.891 3.39 .000 1.00 32

Std. Residual -1.373 2.25 .000 .88 32

a Dependent Variable: Return at Day 1

The sample used here fits the model very well and there is vary little difference

between the observed values and those predicted by the regression equation

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