A Tax-Based Motive for the Underpricing of Initial Public Offerings Author(s): Mary Ann Reside, Richard M.

Robinson, Arun J. Prakash, Krishnan Dandapani Reviewed work(s): Source: Managerial and Decision Economics, Vol. 15, No. 6 (Nov. - Dec., 1994), pp. 553-561 Published by: John Wiley & Sons Stable URL: http://www.jstor.org/stable/2487752 . Accessed: 06/03/2012 04:27
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MANAGERLALAND DECISION ECONOMICS, VOL.

15, 553-561 (1994)

Tax-Based

Motive

For Initial

The

Underpricing Of

Public
Offerings
MaryAnn Reside and RichardM. Robinson
Eastern KentuckyUniversity, Richmond, KY USA

Arun J. Prakashand KrishnanDandapani

Florida International University, Miami, FL, USA

for the pricing of This paper presents a model of entrepreneurial wealth maximization initial public offerings (IPOs). It is an extension of one previouslypresented in the literature.The modelshowsthat personaltax rates on ordinaryincomeand capitalgains may, in part, determineIPO pricing:an increase in the capital gains tax rate should An empiricalanalysis of the effect of the Tax Reform lower the degreeof underpricing. Act of 1986, which raised the capital gains tax rate, shows that the averagedegree of did decreaseas predicted,and that this occurs after controllingfor other underpricing possible influences.

INTRODUCTION Numerous studies have documented significant underpricing of IPOs. In a recent article in this journal, Dandapani et al. (1992, hereinafter DDRP) provide yet another explanation,based of inital on personal taxes, for the underpricing hypothepublicofferings(IPOs).The 'traditional' ses for the underpricingphenomenon include risk-averse underwriter/risk compensation, monopsonypower, agency cost, institutionallag, speculativebubble, implicit insuranceand asymmetric information.See DDPR for a review of these hypotheses. Adding to these traditionalhypotheses,DDPR is depenpropose a model by which underpricing dent on the entrepreneur's (1) personal tax rate on ordinaryincome (and, concomitantly,the applicablecapitalgains tax rate), (2) abilityto defer capital gains, and (3) the proportionof retained ownershipin the firm.They present a theoretical argumentthat there is a tax-basedmotivefor IPO issuers to underprice. This paperextendsthe theoreticalargumentfor a tax-based motive for IPO underpricing.The DDPR entrepreneurial model wealth-maximizing CCC0143-6570/94/060553-09 ? 1994 by John Wiley & Sons, Ltd.

of IPO pricing is reviewed and a considerable extensionof the model is presented.Whereasthe DDPR model shows the influenceof tax rates on the proportionof IPOs underpriced,the extension to the model presented here illustratesthe influenceof tax rates on the degree of underpricing of each IPO issue. In addition,an expanded empirical analysis is presented in this paper as comparedto DDPR. This new empiricalanalysis data set, and also more involvesa much-expanded analysis extensive parametricand nonparametric of the tax effects on IPO underpricing. THEORETICALFOUNDATION The Tax-basedIPO Modelof DDPR The DDPR tax-based model assumes that the purpose of the IPO is to fund a project with positive net present value. To simplifythe analysis, agencyproblemsbetween the issuers and the underwriters, and informational asymmetries between the issuers and the market,or between groups of investors, are assumed nonexistent. Furthermore,the entrepreneur is assumed responsiblefor setting the issue price of the shares.

554

M. A. RESIDE, R. M. ROBINSON, A. J. PRAKASH AND K. DANDAPANI

While correctpricingwould allow full realization of the project's net present value, it may also force the net present value to be received as a currentlyrealized taxable gain. Underpricingthe issue, which could result in a currentlyunrealized capital gain, may therefore be in the best interests of the entrepreneursince the tax would be deferred until the gain is realized. The entrepreneurfaces the problem of pricingthe IPO so that he or she receives the maximumcurrent wealth from the new project. The mntrepreneur may appropriatethe wealth generated by the project by paying himself a dividend(equal to the net present value of the project)priorto the issue,while borrowing against the futurevalue of the projectin orderto finance the dividend.Alternatively, the entrepreneurcan chargethe firma royaltyequal to the net present value and payablefrom the proceedsof the issue. Assuming that there is agreement between the marketand the issuers on the value of the issue, then post-issue,the marketwill price the firm at its presentvalue and it will be indifferenttowards the method that the entrepreneurmight choose for appropriating this 'surplus'net present value. Each of the above methods, however,whether a priordividendor a royaltyschedule,imposesa tax liabilityon the entrepreneur.In addition,for the case of the entrepreneur who retains a portionof the issue, he or she may receive part of his investmentback as realizedtaxablegains. The entrepreneur's decision on the issue price will thereforeaffect his or her returnin two ways, given that the IPO issue price is set below the project'spresent value, and therefore below the marketvalue. The first way is that a higher IPO price increases 'entrepreneurialsurplus' to be appropriated by either a dividendor royalty.This 'surplus'is the difference between the project's cost and the IPO price. The second way is that if some proportionof ownershipis retained by the entrepreneurthrough the purchase of shares of the IPO at the offer price, then a lower issue price increases the capital gain to his or her shares. This capital gain occurs when the share to reflect the preprice rises in the after-market sent value of the funded project. In a world with personal taxes, the entrepreneurial surpluswill be taxed at rates applicable to ordinaryincome. Capital gains will be taxed when realized, and at rates applicable to capital gains income, which prior to 1987 were

typically lower than ordinaryincome tax rates. The theoreticalanalysisthat followsremainsvalid, however,for the currenttax laws,where the ordinary income tax rate equals the capital gains tax rate, due to deferral capability.The former can lead the entrepreneur to set the issue price below the present value of the project so as to receive returnsin the form of capitalgains ratherthan as surplus.The choice of the issue price is modeled below. Let: PV= presentvalue of the proposedproject; C = current period cash outflow needed to finance the project; P = total issue price chosen by the entrepreneur
(C < P < PV);

a =proportion of firm retained by the entrepreneur(O< a < 1); = To entrepreneur'spersonal tax rate on ordinary income; Tk = entrepreneur's tax rate on capital gains income (Tk < To); and

y = a present-valueinterest factor to measure the present value of deferred tax on realized capital gains (O< y < 1), over the entrepreneur'sdesired deferralperiod, where if y = 1, capital gains cannot be deferred and must be realized in the currentperiod, and if y= 0, indefinite deferral would be possible and the capital gains tax could be completelyavoided. The entrepreneur wishes to maximizehis or her wealth, W, which consists of the entrepreneurial
surplus taxed at To, shown as (P
-

C) (1 - To) in The en-

Eqn. (1) below, plus the capital gains taxed at

yTk, shown as (PV-P)Ca(1-yTk).

trepreneursolves the maximization problemgiven by:

Max W= (Pp

C)(1

To) + (PV-P)a
(1)

X(l-yTk)

This equation is similar to the DDPR linear model which, given a, results in corner solutions that indicate whether or not underpricing exists, but does not indicate the degree of underpricing. The model presented in the next section, however, is nonlinear in that a is a function of P. This model results in solutionsfor the magnitude of underpricing.

UNDERPRICING OF IPOS

555

The ExtendedTax-basedIPO Model In order to ascertainthe degree of underpricing, assume that a, the proportionof entrepreneurial retention,is some unspecifiedfunctionof P. That is, allow a to be influencedby the issue price, P, in that the lower the issue price, the higher the proportion of the issue retained.Thiswouldoccur because the lower the issue price, the greaterthe future capital gain to be exploited and the more attractivethe holdingsof the issue wouldbe. This relationis expressedby Eqn. (2), where f(P) is at least a twice-differentiablefunction of P. The maximization problem,therefore,reduces to that expressedby Eqn. (3):
a=f(P) (2)

capitalgains tax rate on the degree of underpricing. This must be accomplishedby finding the impact of a change in this tax rate on the issue price while maintainingthe conditionsnecessary for the wealth maximization. Analysis of the impact of changes in Tk on P, given that the first and second-orderconditionsfor a maximumare maintained,is achievableby taking the total differential of the first-ordercondition, Eqn. (6). Setting this total differentialto zero so that the first-ordercondition continues to be maintained allows analysisof the sign of dP/dTk. This total differentialis givenby Eqn. (8a),whichreducesto Eqn. (8b). Using (8b),we obtain dP/dTk as given by Eqn. (9):
dP{-2f'(1
-

yTk) + (PV-P)f"(1

yTk)}

where
Max W= (P
-

f'(P) < 0:
C)(1
-

+dTky[a-(PV-P)f'] dP( d 2W/dp2)

0 (8a)

To) + (PV- P)f(P)

X(1 - yTk)

(3)
dP/dTk

+ dTk{f(P)y-y(PV-P)f'}
=

=O (8b)

The first-ordercondition for an extremum is given by Eqn. (4), and the second-ordercondition for a maximumis given by inequality(5):
dW/dP = (1
-

-{cyy-

y(PV-P)f'}/(d2W/dP2) (9)

To) -f(P)(1
-

In order to analyze the sign of dP/dTk, note

yTk) =

+(PV-P)f'(1
d2W/dP2
=

underpricing exists, then since f' < 0, it must be that dP/dTk> 0: an increase in the tax rate on <O X(1-yTk) (5) capital gains increases the wealth-maximizing price of the IPO. The wealth-maximizingIPO pricing model If f' < 0, as assumed above, then the secondtherefore indicatesthat an increasein the capital orderconditionrequiresthat f" < 0 providedthat tax rate should cause the issue price to rise gains underpricingexists, i.e. PV> P. The first-order and the of the issue retained by the portion condition,however,reduces to: to decrease.The price rises because entrepreneur PV-P= (6) the capital gain is less attractiverelative to the {(a-(1-TO)/(1-yTk)}/f' surplus-incomecomponent of wealth, and the If f' < 0, as assumed, then for underpricingto proportion retained falls because of the decreased attractiveness of the capitalgain. exist, the followingmust hold:
-2f'(1
-

yTk)

O (4)

that d2W/dP2 < 0 by the second-order condition (5).Also,if y>O, a >O,and(PV-P)>Osothat

yTk) + (PV-P)f"

a < (1-TO)/(1-yTk)

(7)

The InterestRate Effecton Price

In order to investigatethe effects of a change in the discountrate (and thereforethe present-value The Effects of Capital Gains Taxation on interest factor y) on IPO prices, the total differPrice ential of Eqn. (6) is set equal to zero. This allows In the above analysis,the tax rates To and Tk are changes in P and y to occur while maintaining assumedconstant,or exogenousto the maximiza- the first-ordercondition for a maximum.This tion model. Nonetheless, it is the purposeof this differential is presented in Eqn. (10a), which analysisto explain the impact of a change in the together with Eqn. (5), reduces to Eqn. (lOb).

556

M. A. RESIDE, R. M. ROBINSON, A. J. PRAKASH AND K. DANDAPANI

Equation(11) follows from (lOb):

dP{-2f'(1
-

yTk) +f"(PV-P)(1 + dy{Tk[ a

YTk)}

+dy{Tk[ a-(PV-P)f']} dP(d2W/dP2)

-

0 (lOa)
=0 (lOb)

(PV-P)f']} a ]/(d2W/P2)

dP/dy = Tk[(PV-

P)f'

(11)

and f' < O,a > 0 Since PV> P for underpricing, and d2W/dP2 < 0 by the second-ordercondition for a maximumit follows that dP/dy > 0. Assume y = (1 + i)-', where t is the entrepreneur'sdeferral period and i is his or her discount rate. Then dy/di = -t(l +i-'-1, and since t > 0 it must be that dy/di < 0. Also, since and since dP/dy > 0, dP/di = (dP/dyXdy/di), and dy/di < 0, then dP/di < 0. Thus, there is an inverse relationshipbetween the issue price and the discount rate used: an increase in the disuses to evaluate count rate that the entrepreneur the present value of the tax deferral lowers the price of the IPO. wealth-maximizing of TheoreticalFoundation Summary where the degree A model of IPO underpricing, of underpricingis dependent upon the issuer's proportionof retained ownership,applicabletax rates on income and capital gains, and capital is presentedabove.Since gainsdeferralcapability, the Tax Reform Act of 1986, capital gains have been taxed at the personal tax rate for tax years beginning after 1986. Analysis of the necessary conditions for tax-related underpricingreveals that if issuersbase their pricingdecisions,at least in part, on the tax treatment of surplus and/or subsequentcapitalgains from an IPO, then IPOs subsequentto the tax should be less underpriced reform, and as a result, the average degree of should be less. That is, in the presunderpricing ence of special lower capital gains tax rates, the should be greater. degree of underpricing EMPIRICAL ANALYSIS generally Empiricalanalysesof IPO underpricing study the initial excess returns; i.e. returns in excess of the market average rate of return. In

the IPO returnis measuredfrom offer particular, date to date of first trade in the secondarymarket, and the IPO returnis adjustedby the return on the market index. This initial excess (marketadjusted)returnfor an IPO is definedin the same manner as McDonald and Fisher (1972), Block and Stanley (1980), Neuberger and LaChapelle (1983), and others. Although the model does not explicitlyconsider the risk of an individualstock issue, market effects on the returns of IPOs are taken into considerationas noted by McDonald and Fisher (1972) and Beatty and Ritter (1986). The Data Two basic, desirable features of the stocks included in the samplewere identifiedpriorto data collection. These are (1) that the issues be of initial,stock-onlyofferings,and (2) that the firms' offeringsbe of variedsize. The latter requirement is necessarysince there may be differingunderpricing effects due to firm size. As Stoll and Curley (1970), Logue (1973), Bear and Curley (1975),Block and Stanley(1980)and Ritter (1984) hypothesized,size may influence the risk of the issue in that largerfirmsmay be better knownto the financialmarketsprior to the IPO, and may be less risky than smaller firms. OTC stocks are that are used in this study so that characteristics restrictedby other stock exchanges,such as firm limited. size, are not artificially listed above is The first'desirablecharacteristic' also important. Common stocks issued in unit offeringsor mixed debt-equityofferingswere not included in the sample since the return process for them may reflect the behavior of the other financialinstrumentsin the offering, and not of the common stock itself. Consequently,the data consist of OTC common stocks that were not offered with warrants or in mixed debt-equity offerings. The data examined for this paper consist of 1308 IPOs of firms'addedto the list' of Standard First-trade & Poor's OTCDaily Stock Quotations. prices were gathered from the same source as were levels of the 'OTC IndustrialIndex'. IPO offeringpriceswere gatheredfrom Moody'sOTC IndustrialManuals. Firm characteristicssuch as the date of incorporation,pre-offer total assets, and long-termdebt, IPO issue size, underwriter, the date of offer were gathered from the same

UNDERPRICING OF IPOS

557

Moody'ssource. AAA and BBB monthlyindexes of yields were gatheredfrom the monthlyFederal Reserve Bulletins,alongwith monthlyobservations on the CPI. The data span a ten-yearperiodfrom January1980 throughDecember 1989.
Testing the Distribution of Excess Returns

There is a strikingabsence in the IPO underpricing literatureof tests of the specific distribution for excess returns.As noted by Block and Stanley (1980),however,market-adjusted returnsmay not be normally distributed.Student's t-test, theretest statistic for fore, may not be an appropriate initial excess returns. Given that the mean initial excess return for the entire sample is 15.97%, with a standard deviationof 44.51%,andthat the medianis 3.70%, the sample distributionof initial excess returns therefore the population exhibits right-skewness; may not be normally distributed.A chi-square goodness-of-fit test (see Freund, 1971, p.338; Johnston, 1972, p. 426; Anderson et al., 1981, p. 322) of the null hypothesisthat the excess returns are normally distributed was performed. The computed x2 measurefor the samplewas 1702.5. Since, at a 1% level of significance,for a sample size of 1308, the critical value for the x2 is 1443.5,the null hypothesisof normalitycannotbe accepted at the 1% level of significance. The rejection of the normality hypothesis is consistent with the findingof sample right-skewtests on shifts in the excess ness. Nonparametric returnsare appropriatesince the null hypothesis of normally distributed excess returns was not accepted at the 99% confidence level. Risking redundancy,however,both parametricand nontests are presentedbelow. parametric
Testing the Tax Change Effect: Parametric Tests

capital gains tax treatment.If the asset had been purchased after the last day of June 1986, the holdingperiodwould not have been long enough to qualifyfor preferentialcapital gains tax treatment. If the asset had been sold after the last day of December 1986, the Tax Reform Act required the capital gain to be taxed at the investor's ordinaryincome tax rate. In order to test the effect of the Tax Reform Act on excess returns of IPOs, the data set of 1308 returnswas divided into the 1021 observations priorto and includingthe firstsix monthsof subsequentto June 1986 and the 287 observations 1986.The mean excess returnfor the first subperiod is 18.17%;the standarddeviationis 49.36%. The mean excess returnfor the second subperiod is 8.11%;the standarddeviationis 17.08%. The t-statisticfor subperiodone is 11.76, with 1020 degrees of freedom. The t-statistic in the second subperiod is 8.03, with 286 degrees of freedom.Hence, the null hypothesisof no underpricing in either subperiodseparatelycannot be accepted at any reasonableconfidencelevel. The tax-basedmodel of underpricingsuggests that the mean excess return in subperiod one shouldbe greaterthan the mean excess returnin subperiod two. To test the null hypothesis that the mean excess returnin subperiodone was less than or equal to that of subperiodtwo, a pooledvariancet-statisticfor the differencein the means was computed.This t-statisticwas 5.46. Since the critical value for the t is 2.326 at a 99% confidence level, the null hypothesis that the mean excess return in subperiod one is less than or equal to that in subperiod two cannot be accepted. The parametrictests, then, provide evidence that althoughexcess returnsexisted over the entire decade of the 1980s, the degree of excess returnsdecreasedafter the enactmentof the Tax Reform Act of 1986. This is consistent with the model. predictionsof the tax-basedunderpricing Testingthe Tax ChangeEffect: Tests Nonparametric In order to test via nonparametric methods existed in the two subperiwhether underpricing ods a pair-wisesign test was computed.The percentage change in the IPO price (offer price to price of first trade) was pairedwith the percentage change in the OTC Industrial Index that

Priorto January1987,capitalgains on assets held for at least 6 months were taxed at rates lower than ordinaryincome tax rates. The Tax Reform Act of 1986 eliminatedthis practiceand, for each individualinvestor,made capital gains taxable at the investor'sordinary income tax rate. For example, an asset purchasedon the last day of June 1986 and sold for a gain on the last day of December 1986 would have been held for 6 months and would have qualifiedfor preferential

558

M. A. RESIDE, R. M. ROBINSON, A. J. PRAKASH AND K. DANDAPANI

correspondedto the same time period. If the rately. UnadjustedIPO returnswere used as the percentagechange in the IPO price was greater dependent variable. Separate regressions were than that of the Index,then a '+' was recorded;if computed for ranked versus nonranked underit was less than the Index then a' - ' was recorded. writers.2For the entire sample,only the diffusion See Conover(1980,p. 124),Freund(1971,p. 344), index and the total value of the issue were found or Anderson et al. (1981, p. 418) for explanations to have regression coefficients that are signifiof this test. cantlydifferentfrom zero. The numberof positiveobservationsin the first Bear and Curley(1975) includedthe age of the subperiodwas 632, and n was 871. The critical firm, the value of the issue, the precedingyear's value for to.01was 470 (zo.01= 2.326 for a = 1%). earnings, the percentage of cash compensation Since 632 > (871 - 470), the null hypothesisthat and the firm's ex post beta, as explanatory varino underpricing exists in this subperiodcannotbe ables. UnadjustedIPO returns were the depenacceptedas the 99% confidencelevel. dent variable.The regressioncoefficientsfor the The numberof positiveobservations in the sec- firm's ex post beta and noncash compensation ond subperiodwas 185 and n was 143. The criti- were significantly differentfrom zero. The expost cal value for to01 was 240 (zo01= 2.326 for a = beta inclusionis of questionabletheoreticalvalid1%). Since 185 > (243 - 140), the null hypothesis ity, particularlyfor the purpose of this study, that no underpricing exists in this subperiodalso since it could not have been knowna priori by the cannot be accepted at the 99% confidencelevel. financialmarketsgiven that the issues are IPOs. The Mann-Whitney U-test is a nonparametric Tinic (1988) included the reciprocalof the ofmethod used to test the hypothesisthat two sam- feringvalue, the naturallog of the offeringvalue, ples are drawn from identical populations. See and dummy variables for ranked versus nonFreund(1971, p. 347) and Conover(1980, p. 216) rankedunderwriters and for issuingin the month for statisticaldetail.1In this test the two samples of January.The dependentvariablewas marketare arranged jointly as though they compriseone adjustedreturns.Only the coefficientfor the resample,and ranksare assigned,largestto smallest. ciprocal of the offering price was significantly Tied observationsare assigned the mean of the differentfrom zero. two spannedranks.The sum of the ranks of one Beatty and Ritter (1986)includedthe reciprocal of the samples is then compared to a critical of the offering price and an underwriter prestige value in order to test the hypothesis. index as independent variables, along with the The sum of the ranks of the first subperiodis stated number of uses for the funds raised as a 676,535.The Mann-Whitneytest statistic,which proxy for uncertaintyconcerningthe returns to is defined by a standard normal z-statistic, is the investor. The latter variable was found to 26.10. The null hypothesisthat the samples are have no effect. The coefficientfor the reciprocal drawnfrom identical distributionscannot be ac- of the offer price was significantly differentfrom cepted at any meaningful level of significance. zero. The dependentvariablewas the market-adThe alternativehypothesisthat the underpricing justed rate of return. is greater for the first subperiod than for the The regressions below use the initialmarket-adsecond cannot be rejected. justed rate of return as the dependent variable. The independentvariablesinclude the firm'sage, the value of the firm'sassets, its debt/asset ratio, Multivariate Analysis the issue value, the underwriter's rankingas inNumerous multiple regression analyses of IPO dexed in Carter and Manaster (1990) and a excess returnshave been presentedin the litera- dummyvariableof '1' for issues after June 1986 ture. The independentvariablesincluded in the and '0' for those issued before.3The real value of regression, however, have varied greatly. Logue the firm'sassets and issue size are also included. In addition, because the pricing model pre(1973) includedthe numberof IPOs offered during the issuingmonth,a Departmentof Commerce sented above shows that IPO prices should be 'Diffusion Index of Common Stock Prices', a dependent upon interest rates via discount facdummyvariable to indicate whether or not the tors, an attemptwas made to use BBB and AAA 'speculative'label was requiredby the SEC, and bond indexes as independentvariables. Because cash and noncash compensationincluded sepa- of the general decline in interest rates over the

UNDERPRICING OF IPOS

559

later years of the 1980s, however,these rate indexes were highly correlated with the dummy variable.The decrease in marginaltax rates that were implementeddue to the Tax Reform Act would cause the supply of loanable funds to increase and rates to fall. This would result from the increase in after-tax rates. The correlation coefficient between BBB yields and the dummy variablewas - 0.72, and betweenAAA yields and the dummyvariablesit was - 0.71. Using either of these rates along with the dummy variable wouldcause severemulticollinearity problemsand make it impossible to discern the effect of the dummy variable from the rate indexes. Hence, the indexeswere omitted from the regressions.4 For the purpose of examiningpossible multicollinearityproblemswith the independentvariables, Table 1 presentsthe correlationcoefficient matrixof the variablesused in the regression.As shown, the dummyvariablehas a correlationcoefficient of 0.20 with the underwriterranking variable.This slight degree of collinearityhas the potential to partially obscure the influence of each upon the dependent variable. The dummy variable also has a slight correlation with the value of the assets and the issue value. These correlations are probably, in part, due to the trend of the 1980swhere the value of inflationary the assets and the issue value increasedin nomi-

nal terms over the decade. Deflating these variables by the CPI lowered their correlations.The more serious correlationproblem exists between the underwriter rankingvariableand the value of the assets and issue. Deflating these variables loweredthe correlationsslightly. The five regressionscomputedand reportedin Table 2 show that the underwriter ranking,debtto-asset ratio, dummyvariableand the age of the firm had coefficients that were significantlydifferent from zero at high probability levels. By the magnitudeof the coefficients,the debt/asset ratio had the largest impact on the IPO returns. The returnsare measuredas percentages,hence a change in the debt/asset ratio from 0.5 to 0.6 has an impactof - 2% on the rate of return.This finding is consistent with James (1992). The dummy variable has the second-largestimpact, with regression coefficients of about -6, which means that the mean excess return for IPOs fell by 6% after the Tax Reform Act was implemented. The underwriterranking variable and the third-largest impact,with coefficientsof about -3. This indicates that a ranking of 9 causes excess returnsto be, on average,lowerby 27% as comparedto underwriter rankingsof 0. In three of the regressions,however,the dummyvariable had significancelevels of 98% rather than the

Table 1. CorrelationCoefficientsof RegressionVariables

RANK TA D/A DUM AGE VAL RET

RANK TA D/A DUM AGE

VAL

1.000
0.328a 0.097a 1.000 0.181a

0.201a 0.131a
0.466a

0.166a
0.091a
0.452a

1.000 0.034 0.016

0.061b

1.000 -0.007
0.167a

1.000
0.053b 1.000

RET RVAL RTA

-0.230a 0.465a

-0.081a

-0.107a 0.065a

-0.071a 0.114a

_0.090a 0.082a

-0.067a

1.000 0.098a

0.2622

0.105a

0.126a

0.088a

0.072a

differentfrom zero at 99%confidencelevel. aSignificantly bSignfficantldifferentfromzero at 95%confidencelevel. 0 to 9, according RANK:Prestigerankingof the managing underwriter, to Carterand Manaster (1990). TA: Total pre-offerassets of the IPO firm($ millions). D/A: Pre-offerdebt-to-asset ratio of the IPO firm. DUM: Dummyvariableto '0' priorto 7/86, or '1' after 6/86. AGE: Age of the IPO firmmeasuredin whole years,0 for firmsof age less than one year. VAl: Total value of the issue ($ millions). RET: IPO initial excess return(%), offer price to firsttradeprice. RVAL:Value of the issue dividedby the CPI ($ millions). RTA: Value of assets dividedby the CPI ($ millions).

560

M. A. RESIDE, R. M. ROBINSON, A. J. PRAKASH AND K. DANDAPANI

Table 2. OLS RegressionCoefficientsa

RANK
TA

-3.04
(4.44)b (

-3.03
4.43)b -0.04

-3.13
(-5.01)b

-3.18
(-4.66)b -0.08

-0.06

(-0.17) D/A DUM AGE

VAL RVAL RTA -13.82

(-0.28) -19.96
(-3.68)b

(-0.34) -20.42
- 3.77)b

-19.95
(-3.68)b

-19.94
(-3.68)b

-6.12
(- 2.06YC

-6.02
(- 2.01)Y

-6.10
(-2.05)Y(

-10.07
3.40)b

-0.48
(-3.62)b

-0.48
(-3.62)b -0.32

-0.48
(-3.63)b

-0.47
- 3.59)b -0.45

(-0.37) (-0.18)
-90.32

(-0.53)

(-0.34) R2 0.05 0.05 0.05 0.04 0.01

t-statistics are in parentheses. return(RET). bThe dependentvariableis the market-adjusted The regressioncoefficientis significantly differentfrom zero at the 99%confidencelevel. CThe regressioncoefficientis significantly differentfrom zero at the 98%confidencelevel.

99% probabilitylevels for the other significant variables. The negative signs of the coefficients for the dummyvariable,the rankingvariableand the age of the firm are all consistent with theoretical predictions.Since the Tax Reform Act lowered the capitalgains tax rates, it is expectedthat IPO returnsshould decrease, as predictedby the taxbased pricing model. This is consistent with the negativecoefficient. The use of higher-prestige underwriters should lower the rate of returnof the issue in the aftermarket.That is, as suggestedin previousstudies, IPOs should be underpricedto a lesser extent if higher-ranked underwriters are used by the issuing firm.The negativeregressioncofficientis consistent with this prediction.An increase in the firm'sage should also lower the IPO returnsince more should be known by the financialmarkets about the older firms;hence; uncertaintyis lower for older firms. The negativecoefficienton the debt/asset ratio is not, however, clearly explained by theory. It mightbe expectedthat the greaterthe debt ratio,

the greater the uncertaintyas to the future returns to the IPO issue holder, and, therefore,the greater the return requiredby the financialmarkets. It could be, however,that those IPO firms that previouslyhad issued debt are better known to the financial markets, possibly favorablyaffecting the acceptanceof their publicequityissue. This could explainthe negativecoefficient.

AND CONCLUSIONS SUMMARY

A theory of tax-based IPO underpricingis presented above. An entrepreneurialwealth-maximizing model is given that shows that deferred capital gains taxes, combinedwith currentlydue ordinaryincome taxes, could partiallyaccountfor The model explicitlypredicts IPO underpricing. that an increase in the capital gains tax rate, ceteris paribus,should result in a lower degree of underpricing. The Tax ReformAct of 1986providesan opporhypothetunityto test this tax-basedunderpricing sis since the Tax Reform Act raised the capital

UNDERPRICING OF IPOS

561 REFERENCES

of gains tax rate. It is shown that the distribution excess returnsdid shift about the implementation date of the Act, and in the directionpredictedby the model. This shift is verifiedby both parametstatisticalmethods. In adric and nonparametric dition, regressionanalyses that control for other factorsand that allowedthe possibleunderpricing IPO returns to shift about the Reform Act's implementationdate via a dummyvariable confirms the predictedtax effect. The empiricalevidence examined is therefore consistent with the predictionsof the tax-basedpricingmodel. Acknowledgements
We would like to thank an anonymousreviewer for the commentswe receivedon the earlierversionsof constructive errorsare our sole responsibility. the paper.Any remaining

NOTES for sam1. The Mann-Whitney U-test is appropriate ples of unequalsize. 2. Among others, Logue (1973) and Tinic (1988) have provideddescriptionsof 'rankedversus nonranked' underwriter (or 'prestigiousversus nonprestigious') groupings.Briefly,the classificationsloosely follow givenby Hayes (1971),where underthe description writers listed at the top of a tombstone have had higherrankthan those at the bottom.Higherrankis with higher stature or prestige in the synonymous community. underwriting 3. The inclusionof the debt/asset ratio shouldprovide more informationto the regressionthan a dummy variable for the presence of debt, as employedby and negative James(1992).Jamesfound a significant relationship between IPO underpricingand the presenceof debt in the firm'scapitalstructureat the time of issue. A value of '1, was assigned to the dummyvariablefor firmswith debt and '0' for firms withoutdebt. The findingsuggeststhat if a firmhas to a previouslyissued debt, the IPO is underpriced lesser extent than if the firmhas not issued debt. 4. By orthogonalizingcollinear variables, some researchers have attempted to discern their relative influences(see Singh et al., 1991). This assignsone variable to the orthogonalizedresidual, however, It does not is arbitrary. and the choice of assignment powerof each. separatethe true explanatory

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