Cost of Raising Capital-Initial Public Offerings (IPOs) and Seasoned Equity Offerings (SEOs)-In Hong Kong

By Chen, K. C.; Wu, Lifan | Journal of Financial Management & Analysis, July-December 2002 | Go to article overview

Cost of Raising Capital-Initial Public Offerings (IPOs) and Seasoned Equity Offerings (SEOs)-In Hong Kong


Chen, K. C., Wu, Lifan, Journal of Financial Management & Analysis


Introduction

Initial public offerings (IPOs hereafter) of equity and subsequent seasoned equity offerings (SEOs hereafter) are two primary methods in reallocating a firm's ownership in exchange for capital necessary for business expansion. According to Ritter and Welch1, current research on initial public offerings has focused on three areas: reasons for going public, the pricing and allocation of shares, and long-run performance. There are myriad theoretical reasons for firms wanting to go public. The evidence provided by Ritter and Welch suggests that firms go public in response to favorable market conditions, but only if they are beyond a certain stage in their life cycle.

In the U.S.A, the costs of equity offerings consist of both direct costs and indirect costs. The major component of the direct costs of equity offerings is the underwriting spread. During recent years, virtually all investment bankers have charged a seven per cent spread between the price they pay the issuing company and the price at which they sell shares to the public. Other direct costs include lawyer's fees, accountant's costs, printing, engraving, etc. These fees can easily amount to several hundred thousand dollars, which can be a large percentage of a small IPO.

Similarly, indirect costs include the underpricing of the new issues and the foregone time that the senior management spent working on the IPO rather than managing the business. The former can be easily measured by the difference between the offering price and the firstday closing price divided by the offering price, whereas the latter certainly carries a high cost even if it cannot be easily measured.

The underpricing of IPOs is a common phenomenon observed by many researchers around the world (see for example, Ritter2; Ibbotson, et al,3; McGuinness4; Cheung et, al.,5; Lee et al., 6). Academics use the terms first-day returns and underpricing interchangeably. For example, Ritter and Welch report that the average first-day return is 18.8 per cent in a sample of 6,249 IPOs from 1980 to 2001. According to the aforementioned studies, raising capital via IPOs is very costly to the issuing firm. Lee, Lochhead, Ritter and Zhao's later show that the costs of issuing SEOs are lower than their IPO counterparts.

In this study, we will investigate the magnitudes of issuing costs, both direct and indirect costs, associated with IPOs and SEOs in Hong Kong during 1991 and 1996. Hong Kong is of interest because it used to be the only gateway to China. For decades, hundreds of companies from China, Taiwan, and Singapore have tapped the Hong Kong equity market for raising capital and stock listings. Based on a sample of 281 IPOs and 384 SEOs from 1991 to 1996, the average direct cost, which includes the underwriting commission (gross spread), legal, auditing and printing expenses, is 10.44 per cent of the gross proceeds for IPOs and 2.85 per cent for SEOs, respectively. The average indirect cost, measured by post-- issue one-day initial return, is 15.14 per cent for IPOs and 6.26 per cent for SEOs, respectively.

We also discover that on the average, the direct issuing costs associated with IPOs and especially SEOs in Hong Kong are lower than their U.S. counterparts. However, the indirect costs of equity offerings are higher in Hong Kong than in the U.S.A. Furthermore, our result shows that the underpricing of HK IPOs evidenced by high first-day returns is considered as a signal for subsequent equity offerings, which is consistent with Jegadeesh, Weinstein and Welch' study who find strong evidence of a positive correlation between IPO underpricing and the probability and size of subsequent seasoned equity offering in the U.S.A.

High direct and indirect costs for IPOs coupled with relatively low direct costs for SEOs pose an interesting question as to whether an issuing company can implement a share-allocation strategy such that the overall cost of equity offerings is minimized and simultaneously more capital is raised without further diluting ownership. …

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