Week 5: Raising Capital Section A & B

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Master IPO mechanics, costs, underpricing, and the Winner's Curse phenomenon for both exam sections.

🎯 Exam Relevance: Raising capital is one of four core topics for Section A (news analysis) and appears in Section B calculations. Know IPO methods (firm commitment, best efforts, auction), underpricing explanations (asymmetric info, signaling), and performance patterns.
Score: 0/7

Essential IPO Formulas

1. Initial Return (Underpricing)

Initial Return
Initial Return = (PFirst Trading Day − PIssue) / PIssue

What it measures: The percentage gain (or loss) from the offer price to the first day closing price. A positive return indicates underpricing—the shares were offered below their market value.

⚠️ Exam tip: This is an indirect cost to the issuing firm because they "left money on the table."

2. Net Proceeds (Money Raised)

Net Proceeds
Money Raised = PIssue × NShares − Underwriting Fee

What it measures: The actual cash the company receives after paying the investment bank's commission.

Common mistake: Students sometimes forget to subtract the underwriting fee. The underwriting fee is calculated as: Fee Rate × (PIssue × NShares)

3. Total IPO Cost

Total Cost
Total Cost = Direct Cost + Indirect Cost
Direct Cost
Underwriting Fee
Fee Rate × Gross Proceeds
Indirect Cost
Underpricing
(PMarket − PIssue) × NShares

Practice Problem: IPO Returns & Costs

Problem 1 – Avista IPO Section B Style

Scenario: Avista is about to go public by issuing 10 million shares at an offer price of €25 per share. The underwriter will charge a 7% underwriting fee. On the first day of trading, Avista opens with a stock price of €28.

Part A: Initial Return

%

Part B: Money Raised

€ million

Part C: Total Cost

€ million
€ million
€ million

The Winner's Curse in IPOs

Understanding the Curse

The Winner's Curse explains why average IPO returns appear high but individual investor returns may be negative. Here's why:

🔥
Hot IPO
+60%
10:1 → Get 10%
✅
Normal IPO
+10%
4:1 → Get 25%
❄️
Cold IPO
−10%
No oversub → Get 100%
Simple Average Return
⅓ × 60% + ⅓ × 10% + ⅓ × (−10%) = 20%
Allocation-Weighted Return (What You Actually Get)
⅓ × (1/10) × 60% + ⅓ × (1/4) × 10% + ⅓ × 1 × (−10%) = −0.5%
The Curse: You get full allocation only on the IPOs nobody else wants (the losers). On winning IPOs, you're crowded out by informed investors who know which ones will perform well.

Problem 2 – Hot, Normal & Cold IPOs Section B Style

Scenario: Three equally frequent types of IPOs exist. Hot IPOs are oversubscribed 10:1 with +60% return. Normal IPOs are 4:1 oversubscribed with +10% return. Cold IPOs have no oversubscription and −10% return. Allocation is pro-rata.

Part A: Simple Average Market Return

%

Part B: Expected Return (Accounting for Allocation)

%

Concept Check Quiz

Test your understanding of IPO theory and empirical patterns.

1. Which theory best explains why investment banks intentionally underprice IPOs?

2. In a firm commitment underwriting, who bears the risk if shares cannot be sold at the offer price?

3. What does empirical evidence typically show about IPO long-run performance (3-5 years)?

4. According to market timing theory, when should a company prefer to issue equity through an IPO?

Section A Answer Templates

4-Sentence Framework for Raising Capital Questions

Use this structure for Section A news analysis questions about IPOs/raising capital:

📝 Section A Answer Template

1 Identify: The article describes [company] undertaking an IPO / SEO / private placement, which raises the question of [pricing/timing/method choice].
2 Theory: According to [asymmetric information theory / signaling theory / market timing], firms [theoretical prediction relevant to the case].
3 Apply: In this case, [company's] decision to [specific action from article] suggests [interpretation using theory].
4 Implication: This implies [market reaction / stakeholder concern / recommendation], which is consistent with empirical evidence showing [pattern].

Sample: IPO Underpricing Article

Click to reveal sample answer ▼

Question: Article discusses TechCo's IPO where shares jumped 40% on the first day. Explain the cost implications.

Answer:

The article highlights TechCo's significant first-day price jump, indicating substantial IPO underpricing. Underpricing represents an indirect cost to the issuing firm—"money left on the table"—as the firm could have raised more capital by setting a higher offer price. In TechCo's case, the 40% initial return implies shareholders transferred considerable value to initial IPO investors, though this may have been intentional to ensure successful placement and generate positive market sentiment. This underpricing pattern is consistent with asymmetric information theories suggesting underwriters discount prices to compensate uninformed investors for winner's curse risk.

Quick Reference: Key Terms

Term Definition Exam Use
Firm Commitment Underwriter buys all shares and resells; bears pricing risk Most common for large IPOs; higher fees
Best Efforts Underwriter sells what they can; issuer bears risk Used for riskier/smaller offerings
Book Building Underwriter gathers investor demand to set price Helps reduce information asymmetry
Greenshoe Option Over-allotment option (typically 15%) to stabilize price Mechanism to support aftermarket price
Lock-up Period Insiders cannot sell for 90-180 days post-IPO Price often drops when lock-up expires
Winner's Curse Uninformed investors get full allocation only on bad IPOs Explains negative expected returns for retail

📋 Week 5 Exam Checklist

Before moving on, make sure you can: