An empirical analysis of initial public offerings (IPOs) underpricing in Nepal 1.

1 General background
An initial public offering (IPO) is the original sale of companys securities to the wider public for the first time in the primary market (Myers and Brealey, 2003). Public offerings involves raising of funds for corporations from the public through the issuance of various securities in the primary market and is often the only major source of obtaining large sums of fixed rate, long term funds. The decision to go public is one of the most important choices to make for the management and owners of a company. This is an epoch event for the firm since it involves profound changes and creates various opportunities for the future of the business. It can be argued that going public is just a natural stage in the life cycle of the company but that is not necessarily the truth. Naturally, the ability of raising capital in the equity market will provide the company with some financial advantages, giving access to new investment and growth opportunities. Studies within this particular field of corporate finance are not exhaustive, and this result in plenty of areas for further analysis. There are especially two areas within initial public offerings that cause wonder for researcher around the world: the evidence of initial underpricing and the long run underperformance. Why do companies choose to go public if these two issues are as consistent as prior evidences shows? Why do IPO firms put themselves out on the market at a lower price than the fair value, leaving money at the table and why do firms still want to go if they are likely to underperform in the long run? In most cases of IPO, the offering price is systematically lower than its closing price on the first trading day. Because of this, investors can enjoy great benefits by purchasing IPOs on the first trading day and sell them on the second trading day or few trading days later. This phenomenon is called IPO under-pricing and it has been extensively documented in almost every stock market.

The IPO is a very important step when firms prepare to go public for the first time. IPO is one of the major focuses for academic research in economics and finance. The most important characteristic of IPO under-pricing has been the best known and most widely studied. IPO underpricing was firstly found by Ibbotson (1975) and named as the mystery of IPO. Usually, underpricing is measured by the first-day initial return, which is the percentage change from the final offering price of IPO to the closing price on the first trading day. Academics use the terms firstday returns and IPO underpricing interchangeably. Since investors can usually make a large and
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riskless gain by investing in the IPO, it has been noted as one of the ten puzzles in the financial research (Brealey and Myers, 2002). Meanwhile, IPO under-pricing has been found in almost all the stock markets in the world. Generally, IPO under-pricing is relatively higher in the developing markets than in the developed markets (Loughran et al,. 1994). IPOs have been a prominent focus of conceptualization and empirical tests since the 1960s (Reilly and Hatfield, 1969). Much of this attention can be attributed to the increase in IPO activity as a function of the "dot com" phenomenon especially in the late 1990s. Of particular interest to both academicians and practitioners is IPO underpricing. There are evidences that the IPO prices increase substantially on the first trading day and leave considerable amount of money left on the table (Ibbotson et al, 1975). Researchers offered several theories to argue that underpricing of IPO is an equilibrium phenomenon in an efficient capital market which indicates that IPO underpricing is deliberated by the issuers and underwriters for a variety of reasons. Much of the attentions have been paid to the information asymmetry problem. Rock (1986) and Beatty and Ritter (1986), followed by others, argue that issuers were coerced to underprice their IPOs to attract investors. Investors would ask for high returns as there is more uncertainty on the valuation of the IPO due to the information heterogeneity. Others argue that issuers strategically underprice their IPO to signal the favorable prospects of the firm (Allen and Faulhaber (1989), Grinblatt and Hwang (1989) and Welch (1989)). Determinants of the IPO underpricing level vary from firm specific factors (i.e. profitability, size and industry), market condition, to investors behaviors (Welch (1992) and Loughran and Ritter (2002)).

However, empirical evidences show that the relationship between IPO underpricing and its determinants are not consistent across countries and time frame. For example, hiring prestigious underwriter was considered a good way to reduce IPO underpricing level before 1980s (Booth and Smith (1986); Carter and Manaster (1990); Michaely and Shaw (1994)) but prestigious underwriters are associated with higher underpriced IPOs in recent years (Louhgran and Ritter, 2004 and 2008). Initial Public Offerings (IPOs) have attracted significant interest in the marketplace. They have been of interest to investors and researchers due to the significant gains associated with the high-profile IPOs of companies such as Google and EBay (Pencek, Hikmet & Lin, 2009). Underpricing can be seen as a fundamental feature of IPOs and is existent in almost every economy. IPO underpricing, or high IPO return is a phenomenon common to most
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stock markets, regardless of whether these markets are in developed or emerging economies (Ritter, 1984). Though IPOs performances have been well documented in the finance literature, most of the studies have focused on the US, Western Europe and other G7 developed economies (Alli, Subrahmanyam & Gleason, 2010). However, these studies cannot be generalized for a country like Nepal, as the primary markets in Nepal is unique by world standards in many wayslimited volume of trading, few investors, absence of professionalism, early stage of growth, limited information available to investors etc. Thus, this study has been directed towards identifying and examining the underpricing of IPO in the Nepalese primary market

1.2 Statement of the problem

Over the last four decades, a number of IPO studies and empirical examinations have reported that IPO under-pricing does exist (Baron, 1982; Jenkinson, 1990). In the U.S. market, Ibboston et al. (1988) carried out an IPO sample test. They found that the amount of short-run IPO underpricing was 16.3% in the years 1960 to 1987. Aggarwal and Rivoli (1990) also tested 1958 new IPOs issued from 1977 to 1987. They reported that the initial return was about 10.67%. Ibboston and Ritter (1995) concluded a similar answer from their IPO study. The average first-day IPO return was 15.3% over the period 1960-1992. In U.K., Levis (1995) made a sample research of 123 new IPOs issued in the London Exchange Stock Market during 1985 to 1988, He pointed out that IPO was under-priced about 8.6% on the first trading day. In France, Husson and Jacquillat (1990) studied 131 French listing companies from 1983 to 1986. They indicated that the average IPO initial return was 4.0% for the total sample. In Asia, the amount of under-pricing is much higher than other continents. Dawson (1987) examined 21 IPO firms in Hong Kong and 39 IPO firms in Singapore between 1978 and 1983. The initial return was 13.8% and 39.4% respectively. Chi and Padgett (2005) carried out a research on 668 Chinese IPOs from 1996 to 2000, and they indicated that the average initial return was 129.2%. The magnitude of underpricing in China is even more phenomenal. Mok and Hui (1998) found that the underpricing of shares in Shanghai is 289%. Su and Fleisher (1999) showed that the underpricing could exceed 948% if IPOs from earlier years were included in the sample. Sahoo and Rabib (2010) reported that on an average the Indian IPOs are underpriced to 45.55% for the periods of 2002-2006.

Moreover, researchers have found another puzzling fact that IPO under-pricing tends to be larger in certain times. Ibbotson and Jaffe (1975) and Ritter (1984) pointed out that there have been several periods during the postwar in which IPO initial return was extremely high. They reported that IPOs issued in 1950, 1951 and 1980 in U.S. could generate much higher first-day initial returns.

A considerable theoretical literature has attempted to explain the puzzle of IPO under-pricing. Tinic (1988) questioned that why do the issuers agreed to leave lots of money on the table? In the 1970s, Stoll and Curley (1970), Reilly (1973), Logue (1973), and Ibbotson (1975) first documented that there was a systematic increase from the offering price of an IPO to the first day closing price. They listed several possible explanations for the IPO under-pricing, which have been widely adopted and explored by other financial researchers in their later works. One of the most important hypotheses is the asymmetric information theory. Baron (1982) proposed that underwriters have information advantages compared to the issuers. Underwriters own more important and inside information about IPOs. They can possess better information about investors demands for the IPO shares and their expected share price. So underwriters can help issuers go public more efficiently. However, IPO under-pricing may occur inevitably in this asymmetric information environment. Since the issuer cannot always monitor and evaluate the efforts of underwriter, the underwriter may directly sell the shares at a discount, which is not only to minimize their distribution efforts, but also guarantee the share can be absorbed by the market quickly and safely. The issuer may agree to the under-priced IPO due to the need of underwriters superior information support. Later, Beatty and Ritter (1986) proposed the ex-ante uncertainty theory to explain IPO under-pricing puzzle. Before an IPO is issued into the stock market, there must be some uncertain factors which may have adverse impacts on the IPO performance. In order to attract potential investors and achieve a satisfied IPO, the issuer would permit his IPO to be undervalued at first. Namely, the higher the uncertainty level of the firm, the higher the under-pricing level will be. Other theoretical explanations, such as the winners curse theory (Rock, 1986); signaling model (Grinblatt and Hwang, 1989); informational cascades (Welch, 1992) and lawsuit avoidance (Hughes and Thakor, 1992) are all important and indispensable to the IPO study.

Numerous studies worldwide have documented the performance of initial public offering, different levels of underpricing observed in different countries show that there might be some unique features in each country and these features might affect underpricing, such as stated by Loughran et al. (1994), institutional differences in pricing and allocation of shares play an important role in explaining the degree of underpricing. It is thus important to understand the underpricing of IPOs in a specific market, not only from an investment perspective but also for the interest of the issuer as this will give the owners an understanding of future valuation prospects for the organization in terms of market capitalization. In Nepalese context, studies on the operating performance of initial public offering firms are not as extensive but it is almost a very new area. This peculiar situation motivated to choose this topic for research project.

The purpose of this study is to investigate the underpricing of initial public offerings of the Nepal Stock Exchange (NSE) during the period of 2005/006-2009/2010. This study is important so as to educate people about the NSE, particularly about the various issues about going public, the extent of IPO underpricing/overpricing in different sectors and its determinants. This study will provide an insight for the future investors regarding the types of IPOs that is best to invest in as in depth analysis of the issue of underpricing and the stock price behavior shall be explored. Nepalese capital market is unique with an interesting characteristic. Therefore it will be interesting to find out the extent of underpricing and what are the factors that affect underpricing in Nepalese capital market. The study basically deals with followings issues.

a. What is the underpricing level of Nepalese initial public offering? b. What is the level of average initial market return? c. What is the level of initial market adjusted abnormal rate of return? d. Is there significance difference in underpricing levels of different industry? e. Is there any relationship between profitability, solvency and initial return of public offering? f. Do offer size, age and financial leverage of the firm explain the initial return of public offerings? g. How does the gross proceeds, price to book value ratio, net assets per share (NAP), earning per share (EPS) and issue price (P0) effect the initial return?
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h. What are the views of market participants such as managers, directors, executive, and security business persons in relation to factors explaining IPOs in Nepal?

1.3 Objectives of the study

As noted, scant research has been done in Nepalese IPOs. For this reason, this study attempted to gain a deeper understanding concerning the underpricing of IPOs and the relevant factors underpricing this phenomenon. In particular, this research endeavoured to: a. To evaluate underpricing level of Nepalese initial public offering. b. To analyze the level of average initial market return. c. To assess initial market adjusted abnormal rate of return. d. To view the difference in underpricing levels of different industry. i. To identify and analyze the relationship profitability, solvency and initial return of public offering. e. To determine size, age and financial leverage of the firm effect on the initial return of public offerings. f. To recognize and study the effect of the gross proceeds, price to book value ratio, net assets per share (NAP), earning per share (EPS) and issue price (P0) on the initial return. g. To evaluate the practitioners opinion in relation to the factors explaining IPOs in Nepal.

1.4. Research Methodology 1.4.1 Research design

This is the exploratory nature of the study with deductive approach as the primary guideline. Regarding the research method with other components it uses combination of qualitative and quantitative method.

1.4.2 Nature and sources of data

Secondary as well as primary data will be used for the purpose of analysis. Secondary data will be collected from the websites of Nepal stock exchange (NEPSE) and Security board of Nepal (SEBON). And then, Nepal stock exchange and security board of Nepal will be visited to collect the data not available on line. For the opinion survey of practitioners questionnaire will be administered and primary data will be collected.

1.4.3 Selection of enterprises

Study only includes the initial public offerings of the ordinary shares (right shares offering, bonus shares and shares offered to staff are excluded) during the fiscal year 2005/2006 to 2009/2010.

1.4.4 Method of analysis

The methods of data analysis used in the study are divided into three subsections. The first section deals with tools used for analysis of secondary data. This includes calculation of initial return, initial market return, and adjusted market return and regression analysis. The second section deals with the different statistical tools used for validation of model such as F-test, detection of autocorrelation and multicolinearity. The third section provides an overview on methods used for primary data analysis. This includes percentage frequency distribution, cross tabulation, mean ranking scores of responses to Likert scale items and non-parametric test of statistical significance. This study includes the following models. Underpricing level or initial return: R = [(P1 OP)/OP] x100.. (I) Where, R = underpricing or initial return OP = offer price Market return : Rm = [(I1 I0)/ I0] x100 (II) Where, Rm = Market return I1 = Level of general market index at first trading day P1 = price observed at end of first trading day

I0 = Level of general market index at offer date. Market adjusted abnormal rate of return(MAAR): Where, MAAR = R - Rm (III) R = underpricing or initial return Rm = Market return Relationship of Initial return with other Independent variables: Initial return = + P + S + FS + FL+ A + P/BV + NAP + EPS + OP +
0 1 2 3 4 5 6 7 8 9

GP + (IV)
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Where, P = profitability S = solvency FS = firm size FL = financial leverage A = age of the firm P/BV = price to book value ratio NAP = net assets per share EPS = Earnings per share OP = offer price GP = gross proceeds

Summary of explanatory variables and their expected relationship with prior reference are as below: Expected Prior studies Variables Definitions/ proxies sign Purnanadam and Profitability EBITDA divided by pre-IPO Positive revenue of the firm. Swaminathan (2004) Total assets less total liabilities Hogholm (1994) Solvency Positive Firm size Financial leverage Age of the firm Price to book value ratio Net assets per share Market capitalization of the firm. Value of long term debt over the market value of equity Negative Negative Gregoriou (2006) Hgholm (1994), Purnanadam and Swaminathan (2004), Su (2004) Ritter (1991), Bhabra and Pettway (2003) Purnanandam and Swaminathan (2004). Li Pinzhen ( 2008 )

The difference between the date Negative of incorporation and the date at which the company goes public. The ratio of offer price to the Positive book value of the firm (per share) at the IPO date. Total assets divided by no. of shares.

Earnings per Net income divided by no. of share shares. Offer price Gross proceeds The issue price of new shares. Gross proceed calculated as number of shares in the offer times the offer prices.

Li Pinzhen ( 2008 )

Li Pinzhen ( 2008 ) Beatty and Ritter (1986), McGuiness (1992), Clarkson and Merkley (1994), Holgholm (1994), Lee et al (1996a and 1996b), and Uddin (2008)

1.4 Organization of the study This study is organized into a total five chapters. Chapter one contains general background of the study including statement of the problem, objectives of the study and organization of the study. The chapter two consists of conceptual review, review of literatures to related international
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studies as well as the review of studies in Nepalese context. Besides, this chapter ends up with concluding remarks associated to the findings and major ideas of national and international studies. This chapter three covers the research design, nature and sources of data selection of data, selection of enterprises, models used for data analysis and conclusion along with the limitations of the methodology. The chapter four basically focuses on the systematic presentation and analysis of data. This chapter is further divided into three sections, to be precise, analysis of secondary data, analysis of primary data and concluding remarks associated with the major findings of the study. The chapter five provides a summary of overview on all works carried out in chapter one through four including major conclusions derived from the study that are consistent or contradicted with past studies. This section also includes a separate section for recommendations about selection of variables, study period, number of firms that are expected to be more beneficial for upcoming studies.

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