A Tax-Based Motive for the Underpricing of Initial Public Offerings

Mary Ann Reside; Richard M. Robinson; Arun J. Prakash; Krishnan Dandapani

Managerial and Decision Economics, Vol. 15, No. 6. (Nov. - Dec., 1994), pp. 553-561.
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MANAGERIAL AND DECISION ECONOMICS, VOL.

15,553-561 (1994)

A Tax-Based Motive For The

Underpricing Of Initial

Public

Offerings

Mary Ann Reside and Richard M. Robinson

Eastern Kentucky Uniwrsity, Richmond, KI: USA

Arun J. Prakash and Krishnan Dandapani

Florida International Uniwrsity, Miami, FL, USA
This paper presents a model of entrepreneurial wealth maximization for the pricing of
initial public offerings (IPOs). It is an extension of one previously presented in the
literature. The model shows that personal tax rates on ordinary income and capital gains
may, in part, determine IPO pricing: an increase in the capital gains tax rate should
lower the degree of underpricing. An empirical analysis of the effect of the Tax Reform
Act of 1986, which raised the capital gains tax rate, shows that the average degree of
underpricing did decrease as predicted, and that this occurs after controlling for other
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
on personal taxes, for the underpricing of inital
public offerings (IPOs). The 'traditional' hypotheses for the underpricing phenomenon include
risk-averse underwriter/risk compensation,
monopsony power, agency cost, institutional lag,
speculative bubble, implicit insurance and asymmetric information. See DDPR for a review of
these hypotheses.
Adding to these traditional hypotheses, DDPR
propose a model by which underpricing is dependent on the entrepreneur's (1) personal tax rate
on ordinary income (and, concomitantly, the applicable capital gains tax rate), (2) ability to defer
capital gains, and (3) the proportion of retained
ownership in the firm. They present a theoretical
argument that there is a tax-based motive for IPO
issuers to underprice.
This paper extends the theoretical argument for
a tax-based motive for IPO underpricing. The
DDPR entrepreneurial wealth-maximizing model

CCC 0143-6570/94/060553-09

O 1994 by John Wiley & Sons, Ltd.

of IPO pricing is reviewed and a considerable

extension of the model is presented. Whereas the
DDPR model shows the influence of tax rates on
the proportion of IPOs underpriced, the extension to the model presented here illustrates the
influence of tax rates on the degree of underpricing of each IPO issue. In addition, an expanded
empirical analysis is presented in this paper as
compared to DDPR. This new empirical analysis
involves a much-expanded data set, and also more
extensive parametric and nonparametric analysis
of the tax effects on IPO underpricing.

THEORETICAL FOUNDATION
The Tax-based IPO Model of DDPR
The DDPR tax-based model assumes that the
purpose of the IPO is to fund a project with
positive net present value. To simplify the analysis, agency problems between 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 responsible for setting the issue price of the shares.

554

M. A.

RESIDE, R. M. ROBINSON, A. J.

While correct pricing would allow full realization

of the project's net present value, it may also
force the net present value to be received as a
currently realized taxable gain. Underpricing the
issue, which could result in a currently unrealized
capital gain, may therefore be in the best interests of the entrepreneur since the tax would be
deferred until the gain is realized. The entrepreneur faces the problem of pricing the IPO
so that he or she receives the maximum current
wealth from the new project.
The entrepreneur may appropriate the wealth
generated by the project by paying himself a
dividend (equal to the net present value of the
project) prior to the issue, while borrowing against
the future value of the project in order to finance
the dividend. Alternatively, the entrepreneur can
charge the firm a royalty equal to the net present
value and payable from the proceeds of the issue.
Assuming that there is agreement between the
market and the issuers on the value of the issue,
then post-issue, the market will price the firm at
its present value and it will be indifferent towards
the method that the entrepreneur might choose
for appropriating this 'surplus' net present value.
Each of the above methods, however, whether a
prior dividend or a royalty schedule, imposes a tax
liability on the entrepreneur. In addition, for the
case of the entrepreneur who retains a portion of
the issue, he or she may receive part of his
investment back as realized taxable gains.
The entrepreneur's decision on the issue price
will therefore affect his or her return in two ways,
given that the IPO issue price is set below the
project's present value, and therefore below the
market value. The first way is that a higher IPO
price increases 'entrepreneurial surplus' to be
appropriated by either a dividend or royalty. This
'surplus' is the difference between the project's
cost and the IPO price. The second way is that if
some proportion of ownership is retained by the
entrepreneur through 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
price rises in the after-market to reflect the present value of the funded project.
In a world with personal taxes, the entrepreneurial surplus will be taxed at rates applicable to ordinary income. Capital gains will be
taxed when realized, and at rates applicable to
capital gains income, which prior to 1987 were

PRAKASH AND K. DANDAPANI

typically lower than ordinary income tax rates.

The theoretical analysis that follows remains valid,
however, for the current tax 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
returns in the form of capital gains rather than as
surplus. The choice of the issue price is modeled
below. Let:
PV = present value of the proposed project;
C = current period cash outflow needed to finance the project;
P = total issue price chosen by the entrepreneur
(C IP IPV);
a =proportion of firm retained by the entrepreneur (0 I a < 1);
To = entrepreneur's personal tax rate on ordinary income;
Tk = entrepreneur's tax rate on capital gains income (Tk < To); and
y = a present-value interest factor to measure
the present value of deferred tax on realized capital gains (0 < y < I), over the entrepreneur's desired deferral period, where
if y = 1, capital gains cannot be deferred
and must be realized in the current period,
and if y = 0, indefinite deferral would be
possible and the capital gains tax could be
completely avoided.
The entrepreneur wishes to maximize his or her
wealth, W, which consists of the entrepreneurial
surplus taxed at To, shown as ( P - C) (1 - To) in
Eqn. (1) below, plus the capital gains taxed at
yTk, shown as (PV-P)a(1 - YT,). The entrepreneur solves the maximization problem given
by:
Max W= ( P - C)(1 -To)

+ (PV-P)a

This equation is similar to the DDPR linear

model which, given a , results in comer 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 solutions for the magnitude
of underpricing.

555

UNDERPRICING OF IPOS

The Extended Tax-based IPO Model

capital gains tax rate on the degree of underpricing. This must be accomplished by finding the
In order to ascertain the degree of underpricing,
impact of a change in this tax rate on the issue
assume that a , the proportion of entrepreneurial
price while maintaining the conditions necessary
retention, is some unspecified function of P. That
for the wealth maximization. Analysis of the imis, allow a to be influenced by the issue price, P,
pact of changes in Tk on P, given that the first
in that the lower the issue price, the higher the
and second-order conditions for a maximum are
proportion of the issue retained. This would occur
maintained, is achievable by taking the total difbecause the lower the issue price, the greater the
ferential of the first-order condition, Eqn. (6).
future capital gain to be exploited and the more
Setting this total differential to zero so that the
attractive the holdings of the issue would be. This
first-order condition continues to be maintained
relation is expressed by Eqn. (2), where f ( P ) is at
allows analysis of the sign of dP/dTk. This total
least a twice-differentiable function of P. The
differential is given by Eqn. (8a), which reduces to
maximization problem, therefore, reduces to that
Eqn. (8b). Using (8b), we obtain dP/dTk as given
expressed by Eqn. (3):
by Eqn. (9):
a =f ( P )

where

(2)

f '(PI < 0:

The first-order condition for an extremum is

given by Eqn. (4), and the second-order condition
for a maximum is given by inequality (5):
dW/dP= (1 - To) - f ( P ) ( l
+(PI/-P)fl(l

- yTk)

- yTk) = 0

(4)

d 2 w / d p 2 = -2fr(1 - yTk) + (Pv-P)f"

x (1 - yTk) < 0

(5)

If f ' < 0, as assumed above, then the secondorder condition requires that f" < 0 provided that
underpricing exists, i.e. P V > P. The first-order
condition, however, reduces to:
PV- P = {a- (1 - To)/(l

- yTk)}/fl

(6)

If f ' < 0, as assumed, then for underpricing to

exist, the following must hold:

dP{-2f1(l - yTk) + (PV-P)f"(l - YTk)}

+dTky[a - (PV-P)f11 = O (8a)

d p / d ~ ,= -{ay-

y(pv-p)f1}/(~2~/~p2)
(9)

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

that d2w/dp2 < 0 by the second-order condition
(5). Also, if y > 0, a > 0, and (PV - P ) > 0 so that
underpricing exists, then since f ' < 0, it must be
that dP/dTk > 0: an increase in the tax rate on
capital gains increases the wealth-maximizing
price of the IPO.
The wealth-maximizing IPO pricing model
therefore indicates that an increase in the capital
gains tax rate should cause the issue price to rise
and the portion of the issue retained by the
entrepreneur to decrease. The price rises because
the capital gain is less attractive relative to the
surplus-income component of wealth, and the
proportion retained falls because of the decreased attractiveness of the capital gain.
The Interest Rate Effect on Price

The Effects of Capital Gains Taxation on

Price

In the above analysis, the tax rates To and T, are

assumed constant, or exogenous to the maximization model. Nonetheless, it is the purpose of this
analysis to explain the impact of a change in the

In order to investigate the effects of a change in

the discount rate (and therefore the present-value
interest factor y ) on IPO prices, the total differential of Eqn. (6) is set equal to zero. This allows
changes in P and y to occur while maintaining
the first-order condition for a maximum. This
differential is presented in Eqn. (lOa), which
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):

particular, the IPO return is measured from offer

date to date of first trade in the secondary mardP{-2f1(l - yTk) +f " ( P V - P ) ( l - yTk)}
ket, and the IPO return is adjusted by the return
+ dy{Tk[a - ( P v - P )f']} = 0 ( 1 0 ~ ) on the market index. This initial excess (marketadjusted) return for an IPO is defined in the same
d ~ ( d ~ w / +d d~y~{ )~ ~ [(PV( ~ - p)fl]} = o
manner as McDonald and Fisher (1972), Block
(lob) and Stanley (1980), Neuberger and LaChapelle
(1983), and others. Although the model does not
explicitly consider the risk of an individual stock
issue, market effects on the returns of IPOs are
taken into consideration as noted by McDonald
Since PV > P for underpricing, and f ' < 0,a > 0 and Fisher (1972) and Beatty and Ritter (1986).
and d2w/dp2 < 0 by the second-order condition
for a maximum it follows that dP/dy > 0.
Assume y = (1 + i)-', where t is the enThe Data
trepreneur's deferral period and i is his or her
discount rate. Then dy/di = -t(l + i)-'- l, and Two basic, desirable features of the stocks insince t > 0 it must be that dy/di < 0. Also, since cluded in the sample were identified prior to data
d P/di = (d P/d y Xd y/di), and since d P/dy > 0, collection. These are (1) that the issues be of
and dy/di < 0, then dP/di < 0. Thus, there is an initial, stock-only offerings, and (2) that the firms'
inverse relationship between the issue price and offerings be of varied size. The latter requirement
the discount rate used: an increase in the dis- is necessary since there may be differing undercount rate that the entrepreneur uses to evaluate pricing effects due to firm size. As Stoll and
the present value of the tax deferral lowers the Curley (1970), Logue (1973), Bear and Curley
(1973, Block and Stanley (1980) and Ritter (1984)
wealth-maximizing price of the IPO.
hypothesized, size may influence the risk of the
issue in that larger firms may be better known to
Summary of Theoretical Foundation
the financial markets prior to the IPO, and may
A model of IPO underpricing, where the degree be less risky than smaller firms. OTC stocks are
of underpricing is dependent upon the issuer's used in this study so that characteristics that are
proportion of retained ownership, applicable tax restricted by other stock exchanges, such as firm
rates on income and capital gains, and capital size, are not artificially limited.
The first 'desirable characteristic' listed above is
gains deferral capability, is presented above. Since
the Tax Reform Act of 1986, capital gains have also important. Common stocks issued in unit
been taxed at the personal tax rate for tax years offerings or mixed debt-equity offerings were not
beginning after 1986. Analysis of the necessary included in the sample since the return process
conditions for tax-related underpricing reveals for them may reflect the behavior of the other
that if issuers base their pricing decisions, at least financial instruments in the offering, and not of
in part, on the tax treatment of surplus and/or the common stock itself. Consequently, the data
subsequent capital gains from an IPO, then IPOs consist of OTC common stocks that were not
should be less underpriced subsequent to the tax offered with warrants or in mixed debt-equity
reform, and as a result, the average degree of offerings.
The data examined for this paper consist of
underpricing should be less. That is, in the presence of special lower capital gains tax rates, the 1308 IPOs of firms 'added to the list' of Standard
& Poor's OTC Daily Stock Quotations. First-trade
degree of underpricing should be greater.
prices were gathered from the same source as
were levels of the 'OTC Industrial Index'. IPO
offering prices were gathered from Moody's OTC
EMPIRICALANALYSIS
Industrial Manuals. Firm characteristics such as
Empirical analyses of IPO underpricing generally the date of incorporation, pre-offer total assets,
study the initial excess returns; i.e. returns in long-term debt, IPO issue size, underwriter, and
excess of the market average rate of return. In the date of offer were gathered from the same

UNDERPRICING OF IPOS

Moody's source. AAA and BBB monthly indexes

of yields were gathered from the monthly Federal
Reserve Bulletins, along with monthly observations
on the CPI. The data span a ten-year period from
January 1980 through December 1989.
Testing the Distribution of Excess Returns

There is a striking absence in the IPO underpricing literature of tests of the specific distribution
for excess returns. As noted by Block and Stanley
(1980), however, market-adjusted returns may not
be normally distributed. Student's t-test, therefore, may not be an appropriate test statistic for
initial excess returns.
Given that the mean initial excess return for
the entire sample is 15.97%, with a standard
deviation of 44.51%, and that the median is 3.70%,
the sample distribution of initial excess returns
exhibits right-skewness; therefore the population
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 hypothesis that the excess returns
are normally distributed was performed. The
computed X 2 measure for the sample was 1702.5.
Since, at a 1% level of significance, for a sample
size of 1308, the critical value for the X 2 is
1443.5, the null hypothesis of normality cannot be
accepted at the 1% level of significance.
The rejection of the normality hypothesis is
consistent with the finding of sample right-skewness. Nonparametric tests on shifts in the excess
returns are appropriate since the null hypothesis
of normally distributed excess returns was not
accepted at the 99% confidence level. Risking
redundancy, however, both parametric and nonparametric tests are presented below.
Testing the Tax Change Effect: Parametric

Tests

557

capital gains tax treatment. If the asset had been

purchased after the last day of June 1986, the
holding period would not have been long enough
to qualify for preferential capital 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
ordinary income tax rate.
In order to test the effect of the Tax Reform
Act on excess returns of IPOs, the data set of
1308 returns was divided into the 1021 observations prior to and including the first six months of
1986 and the 287 observations subsequent to June
1986. The mean excess return for the first subperiod is 18.17%; the standard deviation is 49.36%.
The mean excess return for the second subperiod
is 8.11%; the standard deviation is 17.08%.
The t-statistic for subperiod one 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 hypothesis of no underpricing in either subperiod separately cannot be
accepted at any reasonable confidence level.
The tax-based model of underpricing suggests
that the mean excess return in subperiod one
should be greater than the mean excess return in
subperiod two. To test the null hypothesis that
the mean excess return in subperiod one was less
than or equal to that of subperiod two, a pooledvariance t-statistic for the difference in the means
was computed. This t-statistic was 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 parametric tests, then, provide evidence
that although excess returns existed over the entire decade of the 1980s, the degree of excess
returns decreased after the enactment of the Tax
Reform Act of 1986. This is consistent with the
predictions of the tax-based underpricing model.

Prior to January 1987, capital gains on assets held

for at least 6 months were taxed at rates lower
Testing the Tax Change Effect:

than ordinary income tax rates. The Tax Reform

Nonparametric Tests

Act of 1986 eliminated this practice and, for each

individual investor, made capital gains taxable at In order to test via nonparametric methods
the investor's ordinary income tax rate. For exam- whether underpricing existed in the two subperiple, an asset purchased on the last day of June ods a pair-wise sign test was computed. The per1986 and sold for a gain on the last day of centage change in the IPO price (offer price to
December 1986 would have been held for 6 price of first trade) was paired with the percentmonths and would have qualified for preferential age change in the OTC Industrial Index that

558

M. A.

RESIDE,
R. M. ROBINSON,
A. J.

PRAKASH AND K. DANDAPANI

rately. Unadjusted IPO returns were used as the

dependent variable. Separate regressions were
computed for ranked versus nonranked underw r i t e r ~ For
. ~ the entire sample, only the diffusion
index and the total value of the issue were found
to have regression coefficients that are significantly different from zero.
Bear and Curley (1975) included the age of the
firm, the value of the issue, the preceding year's
earnings, the percentage of cash compensation
and the firm's ex post beta, as explanatory variables. Unadjusted IPO returns were the dependent variable. The regression coefficients for the
firm's ex post beta and noncash compensation
were significantly different from zero. The ex post
beta inclusion is of questionable theoretical validity, particularly for the purpose of this study,
since it could not have been known a priori by the
financial markets given that the issues are IPOs.
Tinic (1988) included the reciprocal of the offering value, the natural log of the offering value,
and dummy variables for ranked uersus nonranked underwriters and for issuing in the month
of January. The dependent variable was marketadjusted returns. Only the coefficient for the reciprocal of the offering price was significantly
different from zero.
Beatty and Ritter (1986) included the reciprocal
of the offering price and an underwriter prestige
index as independent variables, along with the
stated number of uses for the funds raised as a
proxy for uncertainty concerning the returns to
the investor. The latter variable was found to
have no effect. The coefficient for the reciprocal
of the offer price was significantly different from
zero. The dependent variable was the market-adjusted rate of return.
The regressions below use the initial market-adjusted rate of return as the dependent variable.
The independent variables include the firm's age,
the value of the firm's assets, its debt/asset ratio,
Multivariate Analysis
the issue value, the underwriter's ranking as inNumerous multiple regression analyses of IPO dexed in Carter and Manaster (1990) and a
excess returns have been presented in the litera- dummy variable of '1' for issues after June 1986
. ~ real value of
ture. The independent variables included in the and '0' for those issued b e f ~ r e The
regression, however, have varied greatly. Logue the firm's assets and issue size are also included.
In addition, because the pricing model pre(1973) included the number of IPOs offered during the issuing month, a Department of Commerce sented above shows that IPO prices should be
'Diffusion Index of Common Stock Prices', a dependent upon interest rates via discount facdummy variable to indicate whether or not the tors, an attempt was made to use BBB and AAA
'speculative' label was required by the SEC, and bond indexes as independent variables. Because
cash and noncash compensation included sepa- of the general decline in interest rates over the

corresponded to the same time period. If the

percentage change in the IPO price was greater
than that of the Index, then a ' + ' was recorded; if
it was less than the Index then a ' - ' was recorded.
See Conover (1980, p. 124), Freund (1971, p. 3441,
or Anderson et al. (1981, p. 418) for explanations
of this test.
The number of positive observations in the first
subperiod was 632, and n was 871. The critical
value for to,,, was 470 (z,,,, = 2.326 for a = 1%).
Since 632 > (871 - 4701, the null hypothesis that
no underpricing exists in this subperiod cannot be
accepted as the 99% confidence level.
The number of positive observations in the second subperiod was 185 and n was 143. The critical value for to,,, was 240 (z,,,, = 2.326 for a =
1%). Since 185 > (243 - 140), the null hypothesis
that no underpricing exists in this subperiod also
cannot be accepted at the 99% confidence level.
The Mann-Whitney U-test is a nonparametric
method used to test the hypothesis that two samples are drawn from identical populations. See
Freund (1971, p. 347) and Conover (1980, p. 216)
for statistical detail.' In this test the two samples
are arranged jointly as though they comprise one
sample, and ranks are assigned, largest to smallest.
Tied observations are assigned the mean of the
two spanned ranks. The sum of the ranks of one
of the samples is then compared to a critical
value in order to test the hypothesis.
The sum of the ranks of the first subperiod is
676,535. The Mann-Whitney test statistic, which
is defined by a standard normal z-statistic, is
26.10. The null hypothesis that the samples are
drawn from identical distributions cannot be accepted at any meaningful level of significance.
The alternative hypothesis that the underpricing
is greater for the first subperiod than for the
second cannot be rejected.

559

UNDERPRICING OF IPOS

later years of the 1980s, however, these rate indexes were highly correlated with the dummy
variable. The decrease in marginal tax rates that
were implemented due 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
variable was - 0.72, and between AAA yields and
the dummy variables it was -0.71. Using either
of these rates along with the dummy variable
would cause severe multicollinearity problems and
make it impossible to discern the effect of the
dummy variable from the rate indexes. Hence,
the indexes were omitted from the regression^.^
For the purpose of examining possible multicollinearity problems with the independent variables, Table 1 presents the correlation coefficient
matrix of the variables used in the regression. As
shown, the dummy variable has a correlation coefficient of 0.20 with the underwriter ranking
variable. This slight degree of collinearity has 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
inflationary trend of the 1980s where the value of
the assets and the issue value increased in nomi-

nal terms over the decade. Deflating these variables by the CPI lowered their correlations. The
more serious correlation problem exists between
the underwriter ranking variable and the value of
the assets and issue. Deflating these variables
lowered the correlations slightly.
The five regressions computed and reported in
Table 2 show that the underwriter ranking, debtto-asset ratio, dummy variable and the age of the
firm had coefficients that were significantly different from zero at high probability levels. By the
magnitude of the coefficients, the debt/asset ratio had the largest impact on the IPO returns.
The returns are measured as percentages, hence
a change in the debt/asset ratio from 0.5 to 0.6
has an impact of - 2% on the rate of return. This
finding is consistent with James (1992). The
dummy variable has the second-largest impact,
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 underwriter ranking variable and
the third-largest impact, with coefficients of about
-3. This indicates that a ranking of 9 causes
excess returns to be, on average, lower by 27% as
compared to underwriter rankings of 0. In three
of the regressions, however, the dummy variable
had significance levels of 98% rather than the

Table 1. Correlation Coefficients of Regression Variables

RANK

RANK
TA
D/A
DUM
AGE
VAL
RET
RVAL
RTA

TA

D/A

DUM

AGE

VAL

RET

aSignificantlydifferent from zero at 99% confidence level.

b~ignificantlydifferent from zero at 95% confidence level.

RANK: Prestige ranking of the managing underwriter, 0 to 9, according to Carter and Manaster (1990).
TA:
D/A:
DUM:
AGE:
VAI:
RET:
RVL:
RTA:

Total pre-offer assets of the IPO firm ($ millions).

Pre-offer debt-to-asset ratio of the IPO firm.
Dummy variable to '0' prior to 7/86, or '1' after 6/86.
Age of the IPO firm measured in whole years, 0 for firms of age less than one year.
Total value of the issue ($ millions).
IPO initial excess return (%), offer price to first trade price.
Value of the issue divided by the CPI ($ millions).
Value of assets divided by the CPI ($ millions).

M. A.

RESIDE, R. M. ROBINSON, A. J.

PRAKASH AND K. DANDAPANI

Table 2. OLS Regression Coefficientsa

RANK
TA
D/A

DUM
AGE
VAL
RVAL
RTA
R~

t-statistics are in parentheses.

"The dependent variable is the market-adjusted return (RET).
bThe regression coefficient is significantly different from zero at the 99% confidence level.
'The regression coefficient is significantly different from zero at the 98% confidence level.

99% probability levels for the other significant

variables.
The negative signs of the coefficients for the
dummy variable, the ranking variable and the age
of the firm are all consistent with theoretical
predictions. Since the Tax Reform Act lowered
the capital gains tax rates, it is expected that IPO
returns should decrease, as predicted by the taxbased pricing model. This is consistent with the
negative coefficient.
The use of higher-prestige underwriters should
lower the rate of return of the issue in the aftermarket. That is, as suggested in previous studies,
IPOs should be underpriced to a lesser extent if
higher-ranked underwriters are used by the issuing firm. The negative regression cofficient is consistent with this prediction. An increase in the
firm's age should also lower the IPO return since
more should be known by the financial markets
about the older firms; hence; uncertainty is lower
for older firms.
The negative coefficient on the debt/asset ratio
is not, however, clearly explained by theory. It
might be expected that the greater the debt ratio,

the greater the uncertainty as to the future returns to the IPO issue holder, and, therefore, the
greater the return required by the financial markets. It could be, however, that those IPO firms
that previously had issued debt are better known
to the financial markets, possibly favorably affecting the acceptance of their public equity issue.
This could explain the negative coefficient.

SUMMARY AND CONCLUSIONS

A theory of tax-based IPO underpricing is presented above. An entrepreneurial wealth-maximizing model is given that shows that deferred
capital gains taxes, combined with currently due
ordinary income taxes, could partially account for
IPO underpricing. The model explicitly predicts
that an increase in the capital gains tax rate,
ceteris paribus, should result in a lower degree of
underpricing.
The Tax Reform Act of 1986 provides an opportunity to test this tax-based underpricing hypothesis since the Tax Reform Act raised the capital

56 1

UNDERPRICING OF IPOS

gains tax rate. It is shown that the distribution of

excess returns did shift about the implementation
date of the Act, and in the direction predicted by
the model. This shift is verified by both parametric and nonparametric statistical methods. In addition, regression analyses that control for other
possible underpricing factors and that allowed the
IPO returns to shift about the Reform Act's
implementation date via a dummy variable confirms the predicted tax effect. The empirical evidence examined is therefore consistent with the
predictions of the tax-based pricing model.
Acknowledgements
We would like to thank an anonymous reviewer for the
constructive comments we received on the earlier versions of
the paper. Any remaining errors are our sole responsibility.

NOTES
1. The Mann-Whitney U-test is appropriate for samples of unequal size.
2. Among others, Logue (1973) and Tinic (1988) have
provided descriptions of 'ranked versus nonranked'
(or 'prestigious versus nonprestigious') underwriter
groupings. Briefly, the classifications loosely follow
the description given by Hayes (1971), where underwriters listed at the top of a tombstone have had
higher rank than those at the bottom. Higher rank is
synonymous with higher stature or prestige in the
underwriting community.
3. The inclusion of the debt/asset ratio should provide
more information to the regression than a dummy
variable for the presence of debt, as employed by
James (1992). James found a significant and negative
relationship between IPO underpricing and the
presence of debt in the firm's capital structure at the
time of issue. A value of '1' was assigned to the
dummy variable for firms with debt and '0' for firms
without debt. The finding suggests that if a firm has
previously issued debt, the IPO is underpriced to a
lesser extent than if the firm has not issued debt.
4. By orthogonalizing collinear variables, some researchers have attempted to discern their relative
influences (see Singh et al., 1991). This assigns one
variable to the orthogonalized residual, however,
and the choice of assignment is arbitrary. It does not
separate the true explanatory power of each.

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A Tax-Based Motive for the Underpricing of Initial Public Offerings
Mary Ann Reside; Richard M. Robinson; Arun J. Prakash; Krishnan Dandapani
Managerial and Decision Economics, Vol. 15, No. 6. (Nov. - Dec., 1994), pp. 553-561.
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Notes
2

On the Pricing of Unseasoned Equity Issues: 1965-1969

Dennis E. Logue
The Journal of Financial and Quantitative Analysis, Vol. 8, No. 1. (Jan., 1973), pp. 91-103.
Stable URL:
http://links.jstor.org/sici?sici=0022-1090%28197301%298%3A1%3C91%3AOTPOUE%3E2.0.CO%3B2-C

References
Unseasoned Equity Financing
Robert M. Bear; Anthony J. Curley
The Journal of Financial and Quantitative Analysis, Vol. 10, No. 2. (Jun., 1975), pp. 311-325.
Stable URL:
http://links.jstor.org/sici?sici=0022-1090%28197506%2910%3A2%3C311%3AUEF%3E2.0.CO%3B2-G

Initial Public Offerings and Underwriter Reputation

Richard Carter; Steven Manaster
The Journal of Finance, Vol. 45, No. 4. (Sep., 1990), pp. 1045-1067.
Stable URL:
http://links.jstor.org/sici?sici=0022-1082%28199009%2945%3A4%3C1045%3AIPOAUR%3E2.0.CO%3B2-H

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Personal Taxes and the Underpricing of Initial Public Offerings

Krishnan Dandapani; Rafiq Dossani; Arun J. Prakash; Mary Ann Reside
Managerial and Decision Economics, Vol. 13, No. 4. (Jul. - Aug., 1992), pp. 279-286.
Stable URL:
http://links.jstor.org/sici?sici=0143-6570%28199207%2F08%2913%3A4%3C279%3APTATUO%3E2.0.CO%3B2-7

On the Pricing of Unseasoned Equity Issues: 1965-1969

Dennis E. Logue
The Journal of Financial and Quantitative Analysis, Vol. 8, No. 1. (Jan., 1973), pp. 91-103.
Stable URL:
http://links.jstor.org/sici?sici=0022-1090%28197301%298%3A1%3C91%3AOTPOUE%3E2.0.CO%3B2-C

The "Hot Issue" Market of 1980

Jay R. Ritter
The Journal of Business, Vol. 57, No. 2. (Apr., 1984), pp. 215-240.
Stable URL:
http://links.jstor.org/sici?sici=0021-9398%28198404%2957%3A2%3C215%3AT%22IMO1%3E2.0.CO%3B2-O

Small Business and the New Issues Market for Equities

Hans R. Stoll; Anthony J. Curley
The Journal of Financial and Quantitative Analysis, Vol. 5, No. 3. (Sep., 1970), pp. 309-322.
Stable URL:
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