ACCA Advanced Financial Management (AFM) Practice Exam

Why do skeptics argue against underpricing?

1. It reduces investor interest

2. It primarily serves the interests of the underwriters

3. It increases market volatility

4. It leads to reduced company profits

The correct answer is: It primarily serves the interests of the underwriters

Skeptics argue against underpricing primarily because it serves the interests of the underwriters. Underpricing, which refers to setting the initial offering price of a security below its market value, can be beneficial for underwriters in several ways. It typically guarantees a successful sale of the shares, as the lower price attracts more investors and generates a higher demand. This results in a rapid increase in the stock price once it begins trading, which in many cases positively influences the reputation of the underwriters and can lead to future business opportunities. While this practice may help the underwriters manage risk and ensure the success of an initial public offering (IPO), skeptics question the overall benefit to the issuing company and its long-term investors. The company may miss out on raising the full value of its shares, and existing shareholders may feel diluted as their equity is devalued relative to the potential actual market price. Therefore, this perspective emphasizes that underpricing is strategically advantageous to underwriters rather than aligned with the best interests of all stakeholders involved in the IPO process.