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Transcript
CHAPTER II THEORETICAL FOUNDATION Underprice or Initial Return is the different between the price at which the firm’s stock was initially offered and the stock’s closing price on the first day of trading (Ibbotson, 1975; Sidelar, & Ritter, 1988). Initial Public Offering (IPO) of common stock is typically underpriced. This phenomenon has attracted analyst to do a research regarding the factor that affect the Underpricing. It is reported by Loughran & Ritter that underpricing at US market during 1980 – 1989 reach 7% and during 1990 – 1998 hit 15% before reverting to 12% during the post buble period on 2001-2003. Comparing to Indonesia Stock Exchange (IDX) during 2001-2007 the underpricing is 34%. For investor the underpricing is very attractive, but in other hand the issuing firm can not get optimum fund from the IPO. Initial public offering (IPOs) is the process when private company transposes to be public company (where its shares are sold to other publicly). This process usually called as “go public”. Going public provides a fresh source of capital that is critical to the growth of the firm and provide the founder and others stakeholders such as venture capitalist a liquid market for their shares. But this Initial Public Offer are always risky to all parties : IPO issuer, investment banker and investors. It is very difficult when investment banker & Issuer Company are valuing the price initially for IPO since there is no observable market price before and there are no publish information (operating & finance history) from the Issuer Company before. When the 8 9 price is set too low the Issuer doesn’t get the optimum advantage from IPO to raise the capital. But when the price is set too high, potential investor will get inferior return from the investment, hence probably they will not interested to the offer. Consequently, investor doesn’t want to buy the offering from this investment banker with a record of overprice on offering. The accurate price (or close to accurate) of the offering is required to provide advantage to both side. This research will be focused to the relation between the Underpricing of IPO of common stock at IDX and the Risk Factor & other disclosed information from IPO prospectus. The notion is the higher the risk, the higher the return. Obviously it requires empirical study to prove it. Some issuer reported so much Risk Factor; meanwhile the others reported very small Risk. Prospectus is the first formal information disclosure from the issuer company to public. It is expected to inform potential investor regarding the company performance, hence the prospectus has to include critical information that other has to know. We selected information disclose in the prospectus to test its relation with the Underpricing phenomenon such as Risk factor, Company Age, Auditor, Return on Investment and Financial leverage. 2.1. Capital Market, Initial Public Offer and Underpricing Capital market is the place where long-term financial instrument were trade such as long-term bond markets, equity markets and the derivative market for options and future. A growing firm, Government and other institution usually use this capital market to get Fund for its development. In other hand it become the tools for 10 investment. Capital Market is bridging these needs between investor and the firm or institution, as the place where equity can be traded. In Indonesia Capital Market is regulated by “Undang-Undang Pasar Modal No. 8 tahun 1995 tentang Pasar Modal”, and define the Capital Market as “kegiatan yang bersangkutan dengan Penawaran Umum dan perdagangan Efek, Perusahaan Publik yang berkaitan dengan Efek yang diterbitkannya, serta lembaga dan profesi yang berkaitan dengan Efek”. Generally Capital Market has important role for economic growth of the country, it has two main functions: 1. First, as a place where companies or institutions to get Fund for development or having competitive advantage from investor with minimum additional cost of Fund. The gross proceed (the money obtained from the investor) is usually used for expansion, working capital, or other financial leverage. 2. Second, Capital Market is tools for community, financial institution, Pension Fund and government institution to invest in financial instrument such as equity, obligation, mutual fund, bond, etc. So, investors can choose the investment instrument with its risk and characteristic. Indonesian Capital Market has been starting since Dutch colony set up Capital Market in 1912 at Jakarta, it is followed in other city such as Semarang and Surabaya in 1925. At this stock exchange the Dutch Colonial Government effects were traded such as common stock, obligation, bond, etc. It was intended to finance Dutch Colonial Company to expand and spread its wing to other colony. But, during world War Two the activities was halted. In 1977, Indonesian government activates the 11 stock exchange again by forming Badan Pelaksana Pasar Modal (BAPEPAM) which was changed to Badan Pengawas Pasar Modal in 1991. Common stock or equities represent ownership shares in a corporation. Each share of equity entitles its owner to one vote on any matters in corporate governance that are put to a share in the financial benefits of ownership. The IPO provides a fresh source of capital that is critical to the growth of the firm and provide the founder and others stakeholders such as venture capitalist a liquid market for their shares The Company who want to sell it common stock at Capital Market is called “Go Public” which means its share will be owned and traded publicly in Stock Exchange. In the process to going public, the firm will issue initial offer to public, named Initial Public Offer (IPO). The IPO issuer usually assigns investment banking (called underwriter) to prepare the IPO. The investment banking gives an advice to the firm on which it should attempts to sell the securities including preparing the prospectus, road show to potential investor, setting up the price and register to Exchange committee (BEPEPAM). Currently IDX is trading stock, obligation, preference share, right issue and mutual fund. Among those products trading the stock is very attractive. According to McConaughy, Dhatt, & Kim, 1995, Firms undertake an IPO for two primary reasons. The first reason is as a mechanism for assisting the firms’ initial shareholders in diversifying their holdings. The second rationale is to assist managers (often the firms’ founder[s]) in procuring the necessary funding for undertaking new projects. The IPO enables these individuals to sell a portion of their holdings in the firm and utilize the funds generated from the sale of stock to diversify their investment risk (Rock, 1986). Of these two reasons for undertaking an IPO, 12 Arkebauer (1991) found that the need to generate funds to pursue new projects dominated portfolio diversification. Basically IPO enables firm management to pursue growth opportunities. Entrepreneurs routinely leverage themselves to a point where they are unable to further increase either their own or the firm’s debt load. Issuing firm via an IPO can be beneficial which are providing needed funds and reducing the firm’s debt to Assets ratio. As found by Pagano, Panetta & Zingales, 1998, Rock, 1986 that even in those instances where additional commercial credit is available to the entrepreneur, the covenants attached to the loan may be sufficiently restrictive as to hinder his or her ability to pursue opportunities with high-growth prospects, but also high risk. Initial public offerings (IPOs) have been a prominent focus of conceptualization and empirical tests since the 1960s (e.g., Reilly & Hatfield, 1969). It was studied by any parties particularly in the entrepreneurship. Attention to IPO firm research is important for a variety of reasons. One of important reasons is that research can help inform one of the more critical success factors in the development of a firm. Undertaking an IPO moves the firm from the private to the public domain. Few organizational transitions will receive the concentrated attention that an IPO generates, as this generally represents the first time that firm-specific information will be made available to the public. Usually any firm undertaking an IPO will provide a series of documents that contain detail on the firm, the objective uses of the capital generated from the IPO, and the company’s management. Potential investors will carefully reviews these documents in an effort to assess the price/return prospects of taking an equity position at the time of the IPO 13 Initial Public Offer (IPO) The process of offering a firm’s stock to the general public for the first time according “Panduan Go Public” (Jakarta Stock Exchange) theoretically needs 195 days to proceed (see the chart attached), although it is quite complex and lengthy. Upon deciding to undertake an IPO, firm management must first secure the services of a lead underwriter (also commonly referred to as the investment banker). The underwriters assist firms’ managers in preparing the extensive paperwork involved in complying with regulation (Peraturan BAPEPAM No. IX.A.2), including the registration statement, of which the prospectus is a part. is the prospectus is important materials that serve as the primary marketing tool for the firm’s securities. The IPO marketing process is started by what is called a “road show.” Road shows involve the lead underwriters and key firm managers marketing the firm to prospective investors (largely prominent institutional investors) via presentations in major cities and one-on-one meetings with targeted investors such as mutual/hedge fund managers. These presentations are focused on the firm’s operations, products and services, and management. From the road show the firm/investment banker will get feed back on demand for the firm’s stock and serves as a key input in the investment banker’s final determination of the price at which the firm’s stock will initially trade. Upon completion of the road shows, and just prior to the actual first day of trading (typically the day prior to opening day), firm managers and the underwriters preparing the process to set the initial offering price. This is a critical decision point 14 for firm management because once the price has been set, shares cannot be offered to the investors at a higher price the first day of trading regardless of the level of demand (Gordon & Jin, 1993). This process set initial stock price that forms the basis for underpricing where there is difference in price between the initial stock price set by IPO firm managers and the underwriters and the price of the stock at the close of the first day of trading. There are three main stages for company “going Public”, the first is preparing its internal preparedness, the second is requesting permit to register to BAPEPAM, the third is setting up Initial Public Offer (IPO). Before deciding to go public the firm should consider the benefit and the consequences. According to “Panduan Go Public” issued by Bursa Efek Jakarta, the benefits are : a. Providing new sources of fund Obtaining fund for company for development such as increasing working capital or expansion usually become restriction for the company 9 Fresh Cash provided from selling the stock to public. The company can generate a lot of cash and may accept simultaneously with cheaper cost of fund compare to borrowing from the bank. Beside that becomes a public company, the company can do secondary offering. 9 Flexible access to Financial Institutions Becoming public company which its stocks are traded at IDX, will enhance the company reputation particularly in banking sector. It was known because the performance, the information is open publicly and bankers can decided easily when dealing with the public company. Potentially the public company 15 can issued new debt, competitive loan/interest, etc. Usually the credit given to public company is lower then private company. 9 Better Access for public company to enter money market by issuing bond. Usually the investor prefer to take public company which have better reputation. b. Provide competitive advantage for firm development c. Perform merger and acquisition other company through issuing new share d. Improving ability to “Going Concern” e. Better Company Image f. Increasing Company Value Other benefit of Going Public : g. Advantage in increasing capital in the future. Going public company, will be preferable for investor since it has to open to public all the financial performance, Management decision and other critical information. The banker or other potential investor can assess the company prior to invest in the public company. In other hand , if the private company want to issue a bond or debt, baker/potential investor having difficulties to asses the company performance and need extra work to investigate the company performance since the information is asymmetric between the company and the investor. h. Improve liquidity of share holder. The share holder can easily sell its share since the share price is known publicly an dispute to set the selling price, meanwhile the private company doesn’t have a 16 standard price hence, the selling price of the share need more work and evaluation by potential investor. i. Company capitalization is known For company that want to give stock options incentive for its manager, need a fair share price which is difficult for a private company. Beside the benefit obtain from Going Public, there are also some disadvantage to become public company, such as : a. Increase report expenses Since the public company has to inform the shareholder regularly the financial statement and any corporate action, it increase the expenses of the report issues which is sometimes quite expensive.. b. Disclosure Some company actually doesn’t want to open all information or expose it business plan, since it will use by the competitors to improve or follow the business strategy. c. Take over issue Company management have limited veto in public company. Manager will be easily replaced by the new owner when the majority shareholder was changed. For firms undertaking an IPO, usually the price at the first day of stocks trading is higher than the firm’s stock was initially offered, this phenomenon is named Underpricing (Ibbotson, 1975; Ibbotson, Sindelar, & Ritter, 1988; Ritter, 1998). Underpricing phenomenon is a common occurrence and very attractive to financial analyst. In the review of the empirical evidence on the initial return of common stock 17 offering, Smith concluded that the return from offer price to after-market price have exceeded 15%. It simply that underwriter consistently offers the securities at substantial discounts from their values that are set in the after market. In other words, initial public offerings (IPO) appear to be underpriced. Underpricing As mentioned before that Underpricing is the difference between the price at which the firm’s stock was initially offered and the stock’s closing price on the first day of trading. It is a worldwide phenomenon of almost all capital market that the issue price of initial public offerings is below the first trading price on the secondary market. Numerous empirical studies find evidence that the first trading price is about 20 per cent higher than the issue price of the shares on average. For some capital markets this difference comes even up to 55 p.c. and more. For the investor, underprice return significant benefit in the short-term trading. In other hand for issuing firm, the underpricing reduce the money that should be gotten from the IPO or “leaving money on the table”. This is a good business for the investors who subscribed to the issue and received an allocation because they are enabled to realize considerable trading gains in a few days only. On the other hand, there is a considerably lower amount of money which flows into the enterprise (or the remaining shareholder) if the issue price is below the trading price on the secondary markets. Thus, many investments could not be realized. The fact that IPO company rarely complain about leaving the money on the table and it become a puzzle to financial economists. Brealy and Myers (1996) state after discussing an IPO that tripled in value on its first day of trading, “contentment at 18 selling an article for one-third of its subsequent value is a rare quality”. During 19901998 companies going public in United States left more than $27Billion on the table, due to underpricing (Tim Loughran & Jay Ritter, 2002). Underpricing averages just over 16 percent historically (Ibbotson, Sindelar, & Ritter, 1988; see also Krinsky & Rotenberg, 1989; Loughran & Ritter, 2001). During the Internet bubble of 1999 and 2000, however, underpricing was higher at an average of 65 percent (Loughran & Ritter, 2001). In IPO process, the issuer want to get as much as possible the gross proceed from IPO. If the offer price is so high, the issuer will get more money. But investor may et small return from the investment at the share, hence the investor only want to buy the offer price with significant discount. For underwriter, the higher the gross proceed the bigger fee can be obtained. But if the offer price is too high and no much investor want to buy, then the underwriter has to buy the share. The underwriter will be loss and jeopardize its reputation, this is one reason why the IPO frequently underprice. Seha M. Tinic (1988) explained the underpricing theory with the follow reason : a. Risk-Averse-Underwriter Hypothesis Investment bankers purposely underprice new common stocks to reduce their risks and costs of underwriting (the underwriter risk avertions). The underwriter want to reduce the chances of ending up with an unsuccessful issue and the associated losses. Although it may have some superficial appeal, this explanation is not very satisfactory. It fails to address why issuers do not insist on investment 19 bankers to adjust their underwriting spreads to compensate for the risks of the offering. b. Monopsony-Power Hypothesis The investment banker has monopsony power (single buyer) in underwriting common stocks of small firm and it may cause underpricing (Ritter). Their conclusions were based on the observation that large, reputable investment banking firms generally do not accept to underwrite common stocks of small, speculative, start-up firms. Those firms have small acceptance in investment and very high risk. The investment banker particularly for full commitment underwriter has to buy the common stock, since it has liability to sell all stocks. Hence the investment banker tent to underprice those common stock. Ritter stated, "Major bracket underwriters generally refuse to underwrite small offerings from start-up firms, possibly for reputation reasons." According to Ritter, the IPO market is segmented. The IPOs of small firms are underwritten by investment bankers who, for some unexplained reason, can exercise greater bargaining power over the issuers. These investment bankers intentionally underprice the common stocks, to avoid unsold the stocks and merely maintain their reputation. c. Speculative-Bubble Hypothesis Speculative investor who could not get allocations of the oversubscribed IPO share from underwriters at offering price will buy the share from the market with higher price, expecting to get capital gain from the secondary market. Although the offering prices of the IPO firms were consistent with their underlying economic values. Unfortunately, the speculative investor pushed their prices 20 much higher than the offering price. The speculative-bubble hypothesis would imply that the initial positive excess returns of the IPOs should be followed by negative excess returns as the bubble bursts sometime later. d. Symmetric -Information Hypotheses This hypotheses according to Baron model assumes that the investment bankers have more information about investors demand for the securities than the issuers possess and the investor. The investment bankers reputations may help in certifying the quality of the issues and generate demand. The underwriter who has better information of capital market set the offering price since the issuer is uncertain about the market and the equilibrium price of its stock. The issuer has to compensate the investment banker for the use of this superior information by letting him or her offer the securities at a discount from the price expected in the after market. This condition set underprice phenomenon to the IPO firms. In this research we will focus in evaluating the underpricing due to information asymmetry, particularly the Risk factor heading by the issuer and other disclose information that are opened in the prospectus. As we know the prospectus is expected become one tools to share information between the issuer – the underwriter and the potential investor. The prospectus may eliminate the gap in information asymmetry. Normally the company that doesn’t have track record publicly, will be considered riskier by investor. Hence the uniform investor will value underprice on the company. 21 2.2. Prospectus and Risk Factor Undertaking an IPO moves the firm from the private to the public domain. Consistent with “BAPEPAM IX.C.2” regarding “Pedoman Mengenai Bentuk dan Isi Prospektus dalam Rangka Penwaran Umum”, and “Lampiran Keputusan Ketua Bapepam Nomor Kep-51/PM/1996 tanggal 17 Januari 1996”, Any firm undertaking an IPO must provide a series of documents that contain detail on the firm, the intended uses of the capital generated from the IPO, and the firm’s managers. The disclosure of this information are set in IPO prospectus and presentation arrange by underwriter during the road show. Potential investors will carefully scrutinize these documents in an effort to assess the price/return prospects of taking an equity position at the time of the IPO, this will minimize asymmetry information of the potential investor. The investment banker and the issuing firm reports those information needed by investor in Prospectus. There are four critical item has to be included in the prospectus : 9 Prospectus Summary 9 Risk Factor 9 Use of Proceeds 9 Management Discussion and Analysis (MD & A) The underwriter who prepare the prospectus has to include relevant risk factors (such as: new product, few or limited products, inexperienced management, technical risk, seasonality, customer dependence, supplier dependence, competition, 22 legal proceedings pending against company, government regulation) pertaining to the company. The purpose in requiring the firm to detail the relevant risk factors is to provide potential investors the opportunity to fairly assess the uncertainty facing the IPO firm. Firms with greater numbers of risk factors are associated with higher uncertainty (e.g., Beatty & Zajac, 1994; Welbourne & Cyr, 1999). The increase in uncertainty is likely to be associated with higher levels of underpricing. Hence the risk factor has to be detailed particularly to risks that relate to company specific operation. Also by disclosing all the risk factors of the issuer, it will avoid future legal liability by the investor if there is information that is not disclosed and affect the issuer performance. Risk Factors Risk factor disclosure is important beside as obligation for IPO company, it also because corporate transparency about risk is vital for the well-functioning of capital markets. To achieve and maintain an accurate valuation of a company’s stock, confident and well-informed investors are necessary. Issuer firm managers have superior information compare to outside investors, who may not fully understand the underlying risks and rewards of a firms’ business (Hutton 2004), meanwhile the underwriter has better understanding regarding the capital market & potential investor compare to the issuer firm managers. By providing investors with information about the risk associated with carrying out the company’s strategic goals, managers can increase transparency and eliminate disparities between what investors understand and expect and what management can deliver. By having more accurate information 23 for the risk, the investor can value their investment properly, and preventing stock prices to become unpredictable. According to Fuller and Jensen (2002) “trying to mask the uncertainty that is inherent in every business is like pushing on a balloon; smoothing out today’s bumps means they will only pop up somewhere else tomorrow, often with catastrophic results”. Consequently, being clear about the risks and uncertainties involved can prevent severe damage to long-term health of a company that may otherwise result from overvalued corporate equity (Fuller and Jensen 2002). Unfortunately, although managers of issuer recognize the potential benefits of risk disclosure to investors and long-run health of a company, it is still questionable whether managers are forthright about the underlying risks in their firms’ business. On the one hand, they may understand the benefits of risk disclosure and realize that markets will penalize companies that provide inadequate information relative to their peers. Probably one managers perceive that risk disclosure is a competitive advantage in attracting capital and managers may fear litigation and reputation costs if they do not provide sufficient risk information to investors (Skinner 1994 and 1997). Also hiding risk can cause the stock price to fall to a more sustainable level in the shortrun. Additionally, disclosure is not a costless undertaking (Botosan 1999). First, creating and distributing timely and accurate risk information consumes valuable management time. Second, managers may perceive there is a cost imposed on the firm by competitors who exploit the information to the detriment of the disclosing firm. Third, there is the possibility of litigation in connection with a disclosure. Finally, companies may be afraid to set a disclosure precedent they can not stick to 24 (Hutton 2004). Beside those reason, disclose the risk factor may be seen by issuer competitor as weak point and may be used to win the competitor. Another potential problem also occur when trying to regulate risk factor disclosure is that much of the risk information is industry and company specific, and that the most relevant information changes constantly, as a result of rapid economic and technological changes. As stated by Hutton (2004): “relevant information does not lend itself to standardization”. Mostly issuer firms write in a large degree of discretion in drafting risk sections. Actually the narratives must explain in simple language how certain risk factors affect the company, but should exclude risk factors that could apply to any company. It is up to the underwriter to decide which risk factors are significant and should therefore be discussed. Consequently, some have argued that risk sections do not contain reliable information, because the rules are “subjective, open-ended and ambiguous, which allows firms to report almost anything (or nothing) without violating the requirements” (Schrand and Elliot 1998). According to Beatty and Welch (1996), issuers, underwriters and experts can indeed mitigate their exposure to legal liability by disclosing more risk factors in the prospectus. However, by shifting risk to investors, the marketability of an issue is reduced and the issue price should be lowered (Beatty and Welch 1996). The latter mechanism may prevent disclosure of redundant risk factors. According BAPEPAM regulation, basically the prospectus has to content minimum firm risk. Each company has specific Risk factors. Hence disclosing the Risk Factor has to be as detail as possible, so the investor is provided important information to decide the investment plan. The Firm Risk has to include : 25 a) Competitor b) Resources/ material supplies c) Regulation in the country or at foreign country and other permits related to firm operation d) Government policy Risk factors included in the prospectus are expected to be specific to each firm and to reveal important information. As a rationale risk-averse investor, it is expected that the higher the risk, the higher the return. The gain by risk-averse investors is proxied by the underpricing. We expect that the effect of the risk factors will be positive and significant on the underpricing and traders are selective in their valuation of the risk factors. Such factor will be weighted highly and significant compare to others risk, for example, always professionals are concerned with the risk of limited experience of a potential director The risk factors are divided into several categories. Each category consists of related risk factors cited in the prospectuses of our sample. The categories are : 1- Management Issues: Anti-takeover provisions: refers to the provisions in a company’s by-laws that may pose difficulties for an acquisition. Such by-laws have negative effects on possible acquisition attempts. Control by directors: The majority of the power is held by the directors, management and executive officers. And, companies with high level of control by directors will have the same ownership structure after the IPO as well. 26 Control by existing shareholders: The majority of the power is held by existing shareholders and these companies will have the same ownership structure after the IPO. Control by principal shareholders: The majority of the power is held by a principal shareholder or by a very small group of shareholders. As well, the same ownership structure will be in effect after the IPO as well. Dependence on key personnel: The company's operations, finances and/or management may be dependent on a specific key employees who are hard to replace and also expensive to retain. This risk factor is more for the high tech companies where human resources are limited. Limited experience: The management or staff may not have extensive experience in the field of operations. It is also common to have limited experience for the areas towards which the company extends its operations. Human resources & labor issues: The scarcity of qualified employees is seen as a problem especially in narrow very specialized fields of operations. Most of the high tech companies hire international employees to fulfill their qualified employee shortage. The labor issues recently become main problem in some company that need massive labor in production line. Particularly with current reform era, many labor union do strike to urge company fulfill they want. Absolutely it will creat uncertainty to the company. Limited director liability: This refers to the liability of the managing directors’ liability towards the company, its operations and its products are limited. While the 27 company has full liability and this liability is transferred to shareholder's investments, the limited director liability is seen as a risk factor. 2- International Trade Issues: Foreign imports: Retail companies face foreign companies competing in the domestic market and/or competing for a foreign market. High tech companies on the other hand face foreign competition risk in terms of foreign sales. Import transactions: Due to distant locations between domestic companies and foreign companies, domestic companies may face the risk of delayed import transactions. In addition to the risk of costly operational interruption, they also may cause companies to lose reputation. Currency & International trade restrictions: This risk factor includes import restrictions and exchange rate fluctuations. In such, companies with imported material dependency that faces the risk of import restrictions. Such risks pose risks on the flow of operations and sometimes may be vital for its survival. In addition, for high-tech companies import restrictions are referring to restrictions on employing foreign nationals. This implies restrictions on visas and related issues (this is pronounced for software companies). Exchange rate fluctuations refer to a company that is exposed to any changes in foreign exchange rates. This is mostly the case for retail companies that are dependent on imports and/or have high level of foreign sales. High tech companies with dependency on foreign contracts are also exposed to this sort of risk factor. 3- Technological Issues: 28 Intellectual property and intangible assets: A risk factor that is pronounced in the sample of high-tech companies is the dependence on intangible assets and intellectual property. This includes the dependence on the ownership of copyrights, goodwill, trademarks and patents. The loss of these intangible assets due to external factors such as technological changes poses a risk. Rapid technological changes: Rapid technological changes especially for high-tech companies are big threat. These changes may stimulate companies to grow and hence may expose to new risks. Also, these changes may force companies to file for bankruptcy if they could not cope to such changes. 4- Operational Issues: Quarterly fluctuations: This refers to the risk that a company's operations are affected by quarterly fluctuations. Managing growth: Growing companies require additional resources such as new staff, operational know-how and financial aspects. Product liability: Some companies may have product liability as a result of mistakes in products or conducting business. Litigation cases can be very costly. Operating System: This risk is defined as how the company set up the system to achieve the production. Some company reported that failure in equipment or tool in production line will impact significantly to the company performance. The production target is very tight and has to be achieved to support company income. Seasonality, Regional Limitations and Incident: Seasonality is defined as the company's operating results follow a seasonal pattern. Although this seasonality may be similar to quarterly pattern, the seasonality is more explained in terms of seasonal 29 changes rather than strict quarterly pattern. Regional limitations happen when a company has regional existence and regional distribution channels. Retail companies are the ones that are exposed to regional limitations risk due to their dependency on regional resources. Including in this category is also Incident which related to situation that impact to company productivity such as fire, structure failure, etc. Uncertain market and government contract: Uncertain market refers to companies with new products are facing the risk of uncertain market for their products or services. Government contract refers to contracts between companies and the government. Companies are exposed to risks if the contract is not renewed or if it includes high liability clauses. Larger discounts involved with government contracts are also seen as a risk. 5- Financial Issues: Debt service requirements and restrictive covenants: Debt service requirements refer to the risk of any existing debt that the company has before the IPO that needs to be either renewed or refinanced after the IPO. Restrictive covenants refer to any loan agreement that may have restrictions on the company. These restrictions may be operational, financial and/or managerial. Dilution: Dilution refers to the probability of extensive fluctuation of the stock price after the IPO, and the price may be diluted for the IPO. In other words, the price may depreciate immediately after the IPO. This can be seen as a risk of exposure to volatility. Liquidity : Some companies are very dependent to financial liquidity, such as insurance company, finance company, to sustain its operation. When the insurance 30 company can not cover the claim from the client, it will impact to company performance also. Discretion over use of funds: This refers to how the proceeds from an IPO will be used in the sense that the decision is based on the managing directors’ wish. They can be used to pay existing debt or to pay debt servicing. High level of debt: Companies with high leverage ratios are exposed to more financial risks than others. The cost of debt and ability to finance it are also included into the risk. Historical and recent losses: Historical losses refer to those companies with systematic historical losses. Companies show concerns that such patterns may continue and there is a high probability that they may have losses in the future as well. Recent losses refer to a company that realized losses only recently. Although these losses are not historical and they are not part of a historic pattern, the companies’ future operations may be affected with their recent losses. These recent losses may also indicate that the company is not profitable and may not realize any profits in the future. Need for additional financing: A company may need additional financing for growth or to finance historical/recent losses. The ability to provide the needed funds is seen as a risk factor. No dividends: Companies that have never paid dividends and they have no intention of paying any may lose some investors. 31 No prior market: Companies that go for an IPO has no history of any technical analysis about their stock. Therefore, any reference to historic value is not possible. Working capital deficit: Companies' may require more working capital for expanding operations and/or for financing debt. Ability to finance such need is exposed to companies as a risk factor. 6- Market, Economic and regulatory Issues: Competition: refers to the level of competition which is given as a risk for the companies that exist within competitive markets. General economic conditions: This refers to the cyclicality of the macro economic conditions. Although all companies will be affected by such factor, different companies will not be affected in the same way (either in direction and magnitude). Government permit & regulation: Any sort of government regulation that may affect operations, sales and/or financing would have an effect on the companies. Tax regulations are one of the main concerns. Socio and politic situation : this risk very specific to developing country where the political condition is unrest. Particularly to company expose to public issue such as land acquisition, rebellion or terrorism, ect. 2.3. Control Variable (Others Factor affect Underpricing) Beside the risk factors that has to be exposed to investor prior to IPO, the investor will also look for other information that are influencing the Valuation of the IPO. There are several item that probably affect the IPO such as : Auditor Reputation, Firm age, Company size (represented by Gross Proceed), Profitability, Financial 32 leverage And many other. In this research with include some items as control variable to evaluate the risk factors. 2.3.1 Auditor Reputation Company with favorable inside information to present to investors will hire high-quality auditors (Titman & Trueman, 1986). The reputable auditor will become a powerful signal to potential investors, since high-quality auditors will be less subject to pressures from firm management and more discriminating in their audits (Feltham, Hughes, & Simunic, 1991). The auditor clearly understand that failure to disclose negative information in IPO may bring the auditor to shareholder to a lawsuits. The reputable auditor has capacity to audit in detail the company performance and doesn’t want to jeopardize its reputations. As a result of these reputational and legal constraints, entrepreneurs who believe that unfavorable information about the firm and its prospects will negatively impact investors’ perceptions are unlikely to hire high-quality auditors. High-quality auditors, often as a function of their experience with prior IPOs, may be more likely to uncover negative information. Originally there are five high quality auditor, since “Enron” case, the Big Five auditor company became the Big Four only. They are : 1. PricewaterhouseCoopers, affiliated with KAP Drs. Hadi Sutanto & Rekan, Haryanto Sahari & Rekan. 2. KPMG (Klynveld Peat Marwick Goerdeler), affiliated with KAP SidhartaSidharta & Widjaja. 33 3. Ernst & Young, affiliated with KAP Prasetio, Drs. Sarwoko & Sanjaja. 4. Deloitte Touche Thomatsu, affiliated with KAP Hans Tuanakota & Mustofa. When auditor reputation is not maintain properly, then probably they will not get the job to audit in the next years, hence the auditor will keep th equality of its result. Research fromh Wooten (1981) show that the Big four auditor tent to present better performance compare to small audit company (non the Big Four), it is mainly because they maintain its reputations. Also Big Four auditor usually has better resources (competent people, expertise, sophisticated system and proper procedure. Hence in investor see the Big Four auditor as a guarantee that the company has good financial management. In relation with the underpricing, the IPO company who does not hire the Big Four Auditor will have more uncertainty and less acceptance by the investor. Hence the investor will ask bigger discount price to the company that hire non Big Four Auditor. The majority of studies investigating the association between auditor reputation and underpricing have documented a negative relationship (e.g., Beatty, 1989; Feltham, Hughes, & Simunic, 1991; Michaely & Shaw, 1995). Consistent with these findings, and consistent with the premise that high-quality auditors will reduce uncertainty surrounding the IPO. In this research we expect that the IPO company with non Big Four Auditor will return bigger underprice. 2.3.2 Firm Age Young company who don’t have proven track record expose to uncertainty. As Carter, Dark, & Singh, 1998; Ritter, 1984, 1991, state that the age of the firm has served as a surrogate for risk in previous IPO research, i.e., more established firms are less risky. Young firms will have fewer years of published financial data and are 34 less likely to have been assessed by financial analysts. Well establish company have long time experience in operation and had published its performance. Investor prefer to spend the money at experienced firm and if the investor want to invest at young company they will undeprice it. Consistent with the decreased level of uncertainty the offer price tent to be underprice. We expect the company age has positive correlation with the underprice. 2.3.3 Company Size (Gross Proceed) Company size is also at issue. Larger firms, as compared to smaller firms, present less uncertainty for potential investors. Larger organizations, for example, have greater access to resources essential for firm survival and profitability (Finkle, 1998). Also, several studies have found a negative association between firm size and underpricing (e.g., Carter, Dark, & Singh, 1998; Ibbotson, Sindelar, & Ritter, 1988; Ibbotson, Sindelar, & Ritter, 1994; Megginson & Weiss, 1991).The company size is generally represented by the gross proceed (a function of the total number of shares offered with the IPO and the offering price of those shares). Another hypotheses a correlation between firm size and IPO firm performance is that larger firms tend to attract more prestigious underwriters and potential investor. It is very common that the small company may be perceived offering lower performance potential, therefore the underwriter will avoid to bear any loss due to undersubscribed issue. Underwriters will also be concerned about passing on a riskier issue to their clients, thereby jeopardizing future client business. The company size is expected to have negative correlation with the underpricing. In this research the company size is represented by gross proceed which is also named as amount filed by the IPO. Larger IPOs, in terms 35 of the number of shares and the offering price, would normally be offered by big and more established firms, which should reduce the perceived risk of the offering (for discussions, e.g., Carter, Dark, & Singh, 1998; Dunbar, 2000; Jain & Kini, 2000). the smaller offerings are usually more speculative and has greater uncertainty than their larger company. Accordingly, we expect that that IPO gross proceed will be negatively associated with underpricing. 2.3.4 Profitability or Return on Asset Ratio (RoA) The profitability is the indicator how the company operation return profit that show the effectiveness of the company. The potential investor expect more gain obtained when they invest in the IPO company. Hence the bigger the profitability the higher the profit of the IPO company and later on the investor will get more money from their investment in the company. Generally the investor prefer to invest in the company with higher profitability. In the opposite if the IPO company has lower profitability, the investor want bigger discount in the IPO price or lower price of the IPO company. According to Daljono (2000), higher profitably will reduce uncertainty of the company prospect hence it will reduce the underpricing level. Mathematically profitability can be formulized as follow : Profitability (RoA) = 2.3.5 Net Profit Total Assets Financial leverage or Debt to Asset Ratio Financial leverage or Debt to Asset Ratio (DAR) is the indicator of company healthiness. The company with higher DAR (having bigger debt) finance its operation using debt, meanwhile the company with lower DAR, is self financing its capital and 36 operation. Hence the higher debt to assets ratio the riskier the company will be facing. The investor theoretically prefer the company with lower DAR, otherwise investor want to buy the equity with bigger discount price if the issuer have high financial leverage. Janice C.Y. How (2002) mentioned that financial leverage variable correlate with the underpricing, meanwhile Ghozali and Mansur (2002) research found that financial leverage and underwriter reputation has negatively significant correlation with underpricing. In this research we use this indicator as control variable and expects the higher the financial leverage the higher the underpricing of the IPO firm, in other word we expects the financial leverage has positive correlation with the underpricing. The financial leverage can be formulized as follow : Debt to Asset Ratio (DAR) = Total Debt Total Assets