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

Question

BlackTom AI · Accepted Answer

To assess why IPO underpricing occurs, we should evaluate what each theory suggests about the pricing dynamics at the offering.
Option A: Signaling. The idea here is that underpricing serves as a signal to private investors about the firm’s quality, functioning as a mechanism to convey information about true value in a market with asymmetric information. This framework is commonly cited in IPO literature and is considered a plausible driver of underpricing, since higher-quality firms may still underprice to attract investors and reduce information gaps.
Option B: Strategic ownership. This view emphasizes the bookbuilding process and the behavior of incumbents who want to alter the ownership structure, potentially lowering the price offered to certain investors to manage demand or distribution. The notion that demand is manipulated through the process, thereby exerting downward pressure on the offer price, aligns with observed incentives in some IPO settings and is often discussed as a factor contributing to underpricing.
Option C: Tax shield effect. This hypothesis centers on capital structure changes and tax considerations, specifically the tax benefits of debt. It posits that reducing leverage via an IPO would lessen tax shields and could lower firm value, which is an argument about valuation consequences rather than about the pricing mechanism at the offering. Since underpricing is generally about the initial offering price relative to fundamentals at the time of issue, the tax shield channel is not a standard or primary explanation for underpricing itself.
Option D: Institutional allotment. This theory suggests that granting underpricing serves as an incentive to attract institutional investors to participate in the bookbuild, thereby improving certainty of demand and allocation. It directly links underpricing to the strategic objective of securing participation from sizable investors, making it a relevant explanation for underpricing.
Overall, the first, second, and fourth options describe mechanisms or motives that influence how the IPO price is set or how demand is generated, which are consistent with underpricing explanations. The third option focuses on debt-related tax advantages and firm value changes rather than on the pricing dynamics or signaling about the offering, rendering it less relevant as an explanation for underpricing.

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

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