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

Question

BlackTom AI · Accepted Answer

To approach this question, I will evaluate each proposed theory in the context of IPO underpricing and assess whether it provides a plausible explanation.
Option A: '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 argument centers on tax-shield changes due to changes in leverage. While capital structure effects are important for firm value in general, underpricing in IPOs is typically explained by factors tied to information asymmetry and the primary market mechanics (who knows the firm value, how shares are allocated, and incentives of bookrunners and insiders). The tax shield narrative does not directly address why the initial offer price is set below the market value at offering, nor does it explain why underpricing would be widespread or systematically observed across offerings. Therefore, this explanation is not a standard or convincing driver of IPO underpricing.
Option B: 'Strategic ownership: Since incumbent shareholders and managers prefer to reduce the block size of new shareholders, some investors are sorted out in the bookbuilding process. Hence, demand is artificially reduced leading to a downward pressure on the issue price.' This aligns with the strategic-ownership and bookbuilding literature. It suggests managers actively manage the composition of new owners to retain control or influence, which can depress demand or alter the price path, contributing to underpricing as a byproduct of allocation and preemptive strategies. This is a plausible and commonly discussed channel for underpricing.
Option C: 'Signaling: IPOs are like Akerlof’s lemons, so underpricing is used as a signal for the true firm value.' Signaling is a classic explanation for IPO underpricing: firms with higher information asymmetry use underpricing to signal quality to investors, reducing adverse selection and attracting demand. This theory is widely cited and directly addresses why underpricing would occur.
Option D: 'Institutional allotment: In order to attract institutional investors to the bookbuilding process, an indirect reward in form of the underpricing is granted.' The notion that underpricing serves to attract institutional investors during bookbuilding is a standard explanation in the literature. It frames underpricing as a mechanism to ensure robust demand and participation from reputable buyers, which helps pricing success and aftermarket liquidity.
Taken together, options B, C, and D each present a coherent, well-established mechanism linking underpricing to market dynamics, signaling, or allocation to important buyers. Option A, by contrast, discusses tax shields and capital structure effects rather than the information-based or allocation-based channels that drive IPO underpricing. As a result, Option A is the least relevant among the choices for explaining underpricing in IPOs.

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

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