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In the standard theory of corporate finance, supply conditions in the credit markets have traditionally not been considered as prominent determinants of the firm’s financing decisions and resulting capital structure of the firm. Instead, the theory has been primarily demand-driven: in trade-off theory, firms choose the optimal debt-equity ratio such that the marginal tax benefit of issuing one more unit of debt equals the marginal cost of debt (in the form of increased cost of distress and bankruptcy). In the pecking-order theory, firms raise external funds by choosing the instrument that is the most advantageous given the information asymmetry the firm faces.
More recently, this demand-centric approach to understand capital structure has been called into question. Baker and Wurgler (2002) argue that capital structure is the cumulative outcome of a series of financing decisions in which managers take advantage of temporary market misevaluations, while Welch (2004) argues that managers fail to counteract the mechanistic effects of stock returns on their capital structure and therefore capital structure is almost entirely determined by lagged stock returns. These contributions only focus on the equity/debt choice, implicitly assuming a perfect substitutability between different sources of debt.
The stock price performance of initial public offerings (IPOs) has long been a puzzle and researchers are still trying to understand the price behavior of these offerings. On average, IPOs jump up in price considerably on the first day of trading and provide excess returns to investors who are able to buy at the initial offer price and sell immediately in the secondary market. Recent literature examines the activities of underwriters in the aftermarket. These activities are generally referred to as stabilization activities because they provide price support for weak offerings that tend to trade at or below their offer price. Stabalization activities include exercise of the overallotment option, short covering in the aftermarket, and the use of penalty bids to restrict flipping.
This paper integrates the literature on underpricing of IPOs and aftermarket activities. The initial stock price performance of IPOs partly depends on how shares are priced, how they are allocated, and what investors do with these shares. Investment banks have the discretion to allocate IPO shares, and investors have the option to hold onto their allocated shares or to sell them immediately in the aftermarket. Investors who sell their shares in the first few days after trading begins are referred to as flippers and investment banks have implemented schemes to discourage flipping because this activity puts downward pressure on the stock price. Flipping is the term used when shares are sold in the immediate aftermarket by investors who receive an initial allocation at the offer price and does not include purchases in the aftermarket. The lead underwriter does not disclose the proportion of shares allocated to institutions versus individuals, and the public does not know who has flipped shares. However, the lead underwriter and each syndicate member maintain a detailed account of initial allocations and each customer’s flipping activity.
