Declared investment plans and IPO firm value

Abstract

Trueman (1986) argues that an entrepreneur might signal the quality of his information about a firm's investment projects by disclosing the extent to which external capital raised is to be applied to capital expenditure. This article argues that, via Trueman's theory, a higher level of disclosed capital expenditure at the IPO is associated with higher firm values. The results confirm the anticipated significant positive relationship between firm value and the extent to which funds raised at the IPO are applied to investment.

Acknowledgements

The author would like to thank Robert Faff, David Hillier, Robert Hudson, Peter Moizer, Gulnur Muradoglu, Helen Short and Nicholas Wilson for their helpful comments and suggestions.

Notes

¹ Akerlof (1970) considers the impact of information asymmetry in relation to the second hand car market. In a market in which the informational advantage lies with the seller, and in which repeat purchases are infrequent thus providing the seller with an incentive to cheat, all cars would sell for the price of a car of unknown quality (average quality) to persuade buyers to enter the market. High-quality sellers might therefore be tempted to withdraw from the market, driving down the price still further. That is, unless high-quality sellers are able to distinguish themselves from low quality by means of a signal.

² Spence (1973) employs the concept of signalling in relation to the labour market. Here an information asymmetry exists between employees and employers in relation to the quality of employees, with the former assumed to be better informed. In the presence of a pooling equilibrium in which no one group of employees can be distinguished from another, all employees would be paid the same. Spence considers the means by which higher quality workers might set up a separating equilibrium, i.e. distinguish themselves from lower quality workers, and so be rewarded by salary differentials. To establish such a separating equilibrium, the signal adopted must be such that the benefits of setting up the signal outweigh the costs of doing so for higher quality workers alone. A signal such as educational qualifications might be employed to achieve this separating equilibrium under the assumption that obtaining educational qualifications involves considerably less financial and personal cost to higher quality workers, such that the additional salary makes this worthwhile, but this is not the case for lower quality workers.

³ Underpricing is also employed as a signal of IPO value in the two stage signalling theories of Welch (1989), Allen and Faulhaber (1989) and Grinblatt and Hwang (1989). Given the widespread use of lock-in periods on the UK market a two stage signalling strategy is implausible. For a detailed criticism of the use of underpricing as a signalling device see Hill and Wilson (2006).

⁴ This depends upon the concavity of the production function of the IPO firm and is discussed further in Section II.

⁵ Employing a 10% level of significance.

⁶ All London Stock Exchange (LSE) listings must be ‘sponsored’ by an LSE approved advisor and the sponsor will usually act as lead underwriter. In the US the term underwriter is employed to describe the role of the sponsor and in this article the terms ‘underwriter’ and ‘sponsor’ can be assumed to be synonymous.

⁷ The hypotheses and the remainder of this article allow for more than one entrepreneur per firm.

⁸ Introductions refer to IPOs which do not involve the sale of shares at the IPO; investment trusts are companies which specialise in investment in the financial securities of other companies; privatization IPOs involve the sale of securities by the UK government in companies which have been publicly owned.

⁹ This one year time period is commensurate with the study of post IPO capital expenditure by Van Bommel and Vermaelen (2003).

¹⁰ This again is commensurate with Van Bommel and Vermaelen (2003), who start calculating capital expenditure post the IPO from the end of the quarter in which the IPO takes place.

¹¹ The following is an example of the pro rata calculation: an IPO firm lists on 31 May 1995. The last pre IPO accounts are for the period (part year) to 31 December 1994, as disclosed in the prospectus. The normal accounting year end is 31 August and the first post-listing accounts are for the year to 31 August 1995. The period 31 December 1994 to 31 August 1995 includes 5 months pre-listing and 3 months post-listing and post-listing investment for this period is deemed to be 3/8* the investment for the period from 31 December 1994 to 31 August 1995. Investment is measured for a period of 1-year post listing, so in this case 9/12 of the investment for the year to 31 August 1996 will be added to the 3 months from 31 May 1995 to 31 August 1995.

¹² The use of unadjusted values of MULTIPLE does not materially affect the reported regression results.

¹³ This said, it is acknowledged that on the US market the relationship between high-quality underwriters and IPO underpricing was reversed during the 1990s (see Loughran and Ritter, 2004). Loughran and Ritter argue that this was due to (i) prestigious underwriters taking on an increasing number of smaller and younger IPOs, (ii) the fact that issuers were prepared to tolerate underpricing as the price for access to coverage by the underwriters’ star analysts and (iii) that compensation was provided to issuers in the form of a preferential allocation of other hot IPOs to their personal brokerage accounts (spinning).

¹⁴ The author wishes to thank the referee for this suggestion.

¹⁵ The second tier markets are the USM and AIM.

¹⁶ The regression with the P/E ratio as the dependent variable across first tier market companies only.