Which of the following theories is most likely not relevant for explaining the underpricing phenomenon in IPOs?

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Question restatement: Which theory is most likely not relevant for explaining the underpricing phenomenon in IPOs?

Option A: Strategic ownership. This explanation posits that incumbent shareholders and managers prefer to reduce the block size of new shareholders, leading to selective demand during bookbuilding and downward pressure on the issue price. This aligns with the idea that underpricing can be driven by efforts to strategically manage the investor base and allocation to influence short-run demand, a common explanation in IPO underpricing literature.

Option B: Tax shield effect. Since companies reduce their leverage because of the IPO, the reduction in tax shields leads to a decrease in firm value. This theory centers on leverage changes and the tax shield argument. However, underpricing is typically explained by information asymmetry, signaling, incentives in bookbuilding, or ownership considerations, rather than by changes in corporate leverage or tax shields directly affecting underpricing. Therefore, this explanation does not fit the usual mechanisms proposed for underpricing in IPOs and is less relevant.

Option C: Institutional allotment. To attract institutional investors to the bookbuilding process, an indirect reward in the form of underpricing is granted. This is a classic and widely discussed motive: granting underpricing to secure favorable institutional demand and stabilize post-IPO aftermarket performance by ensuring strong early demand from big players.

Option D: Signaling. IPOs are akin to Akerlof’s lemons, so underpricing is used as a signal for true firm value. Signaling theory is a foundational explanation for underpricing: issuing underpriced shares conveys information about quality and reduces information asymmetry between insiders and external investors.

Why A is plausible: Strategic ownership affects allocation and demand, consistent with bookbuilding dynamics and insider–outsider incentives that influence pricing. It captures the strategic element of pricing and ownership dispersion that can contribute to underpricing.

Why B is implausible: The tax shield and leverage channel describes capital structure effects rather than mispricing due to information asymmetry or allocation incentives. While leverage changes can impact firm value, this mechanism does not directly explain why the IPO price is set below true value in the market-making or bookbuilding context. It conflates corporate finance decisions with pricing dynamics in the IPO auction/process, making it a less relevant explanation for underpricing.

Why C is plausible: Granting underpricing to attract institutional investors fits the empirical observation that allocations and demand from institutions can influence the initial pricing and allocation process, creating a beneficial upfront pricing outcome for the issuer and underwriters.

Why D is plausible: Signaling recognizes that IPO underpricing can convey information about quality to the market, reducing adverse selection and explaining why initial prices may be set low despite high-value implications. It is one of the core theoretical explanations for underpricing.

In summary, among the options, the tax shield/leverage channel in B is the least relevant mechanism for explaining IPO underpricing, whereas A, C, and D describe mechanisms commonly discussed in the literature on IPO underpricing.

Corporate Finance (WI000091) (11.08.2025) Lecture Hall Exam

Which of the following theories is most likely not relevant for explaining the underpricing phenomenon in IPOs?

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