Suppose that Mars, a large private company, is planning to do an IPO. The company currently has 40 million shares outstanding, and with the help of its lead underwriter, Morgan Stanley, Mars has decided to issue 5 million shares priced at $32 each. In addition, the company has agreed to an underwriting fee of 7%.

If the company’s stock price rises to $35 after the IPO, how much value is lost by Mars’ existing shareholders because of underpricing (in million)?

Question

Suppose that Mars, a large private company, is planning to do an IPO. The company currently has 40 million shares outstanding, and with the help of its lead underwriter, Morgan Stanley, Mars has decided to issue 5 million shares priced at $32 each. In addition, the company has agreed to an underwriting fee of 7%.

If the company’s stock price rises to $35 after the IPO, how much value is lost by Mars’ existing shareholders because of underpricing (in million)?

BlackTom AI · Accepted Answer

To tackle the question, first identify the key numbers: Mars has 40 million existing shares, plans to issue 5 million new shares at an offer price of $32, and the post-IPO stock price rises to $35. The underwriting fee of 7% reduces the proceeds to the company, but does not change the amount by which existing shareholders’ value is diluted by the underpricing itself.

Option A: 18 million
- Why this is not correct: The standard measure of underpricing cost to existing shareholders is the difference between the market price at which new shares could have been sold (the price after the IPO, $35) and the offering price ($32), multiplied by the number of new shares issued. This yields (35 − 32) × 5,000,000 = 3 × 5,000,000 = 15,000,000. The 18 million figure does not align with this straightforward calculation, and there is no reasonable adjustment here that would produce 18 without misapplying the formula.

Option B: 24 million
- Why this is not correct: A value of 24 million would require a per-share underpricing of 4.8 dollars on 5 million shares, or some other aggregation that does not correspond to the given numbers (35 vs 32) and the 5 million new shares. Since the actual per-share underpricing is 3 dollars, 24 million overstates the dilution from the described scenario.

Option C: 21 million
- Why this is not correct: If you try to mix in the underwriting fee (7% of gross proceeds) into the underpricing calculation, you might wrongly subtract or adjust the net proceeds to the company. However, the standard measure of lost value to existing shareholders due to underpricing focuses on the transfer to new investors from the price jump, which is 15 million. The 21 million figure does not have a clear basis given the data; it would require an alternative, nonstandard interpretation that isn’t supported by the problem setup.

Option D: 15 million
- Why this is correct: The amount of underpricing is the difference between the post-IPO market price ($35) and the offering price ($32), times the number of new shares issued (5 million). So the transfer of value from existing shareholders to new investors is (35 − 32) × 5,000,000 = 3 × 5,000,000 = 15,000,000. This aligns with the conventional calculation of underpricing cost to existing shareholders in an IPO. The underwriting fee reduces the net proceeds to the company, but it does not alter the amount of underpricing conveyed to new shareholders, which is why the 15 million figure remains the appropriate measure of lost value to existing shareholders.

SP25-BL-BUS-F402-4299 Midterm Exam I

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