Dias, D.S.M., Wijesinghe, M.R.P., Madhushani, P.W.G.

, KJM, 2023, 12 (01)

Factors Affecting the Initial Return of Initial Public Offerings (IPOs) and
IPO Underpricing in the Colombo Stock Exchange
Dias, D.S.M.1, Wijesinghe, M.R.P.2, Madhushani, P.W.G.3
1,2,3
Department of Finance, Faculty of Commerce and Management Studies, University of
Kelaniya, Sri Lanka.
1
suleka104@gmailcom, 2ruwanmrp@kln.ac.lk, 3gangam@kln.ac.lk

Abstract
The initial public offering is an important milestone for a company; however, this can be also
turned into a reason which causes great wealth loss as well. The purpose of this study is to
identify the factors affecting IPO initial return and examine the level of underpricing that
prevails in the Colombo Stock Exchange (CSE). The study considers 68 IPOs from 2006 to
2018. The selected factors for the study are ASPI Return, Sector Price/Earnings ratio, Age,
Earnings Per Share, Debt Ratio, Net Asset Value, Return on Asset, Price/Earnings Ratio,
Debt/Equity Ratio, Offer Price, and Over Subscription Rate. Multiple regression results reveal
that ASPI return and over-subscription rate are positively influenced by market-adjusted
initial return (MAIR) and offer price is negatively affected. Underpricing analysis revealed
that the MAIR and the prevailing level of underpricing is raw initial return equal to 14% and
market-adjusted return is 18%. The beverage, food, and tobacco sector, Banking, Finance,
and Insurance sector, and diversified holding sector are identified as highly underpriced
sectors of CSE. It is recommended that Investors must consider capital market variables and
IPO variables for IPO investment decisions regardless of the financial indicators of the
company.

Keywords: Initial public offering, Colombo stock exchange, Underpricing

Copyright: © 2023 Dias, D.S.M., Wijesinghe, M.R.P., Madhushani, P.W.G. This is an open-
access article distributed under the Creative Commons Attribution License, which permits
unrestricted use, distribution, and reproduction in any medium provided the original work is
properly cited.
Correspondence: ruwanmrp@kln.ac.lk

ORCID of authors: Wijesinghe, M.R.P.- https://orcid.org/0000-0002-6708-6641

Madhushani, P.W.G.- https://orcid.org/0000-0001-8071-684X

DOI: https://doi.org/10.4038/kjm.v12i1.7741

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Dias, D.S.M., Wijesinghe, M.R.P., Madhushani, P.W.G., KJM, 2023, 12 (01)

Introduction In the context of developing markets like Sri

Lanka, events such as IPOs can significantly
Initial Public Offering is generally perceived be affected market trends making it
as an important milestone of a company’s impossible to conclude investors on future
lifecycle. It is the process of raising prices. As a result, there are many research
investment capital by a private company or a studies conducted in this area trying to
corporation offering stocks for the first time interpret market behavior and its impacts on
to the public. IPO allows the firm to access future performance (Wijethunga, 2016;
the public equity markets for additional Samarakoon, 2010). However, it is identified
capital necessary to fund future growth. that past studies have not captured the time
Meanwhile, IPO underpricing has drawn a lot lag between the end date of subscribing
of attention in the recent past research studies period and the first trading day and account
undertaken. It is an event that shares of a for the opportunity cost of the investors and
company go public, and are offered to other market changes. In fact, selecting a
investors at a price considerably below the particular sector to invest in is also
price at which they are subsequently traded in problematic. Hence in this study, a thorough
the stock market (Jenkinson & Ljungqvist, analysis will be carried out to identify highly
2001). The primary adverse consequence of underpriced sectors, and determine the
underpricing is the wealth loss faced by the primary factors affecting the initial return and
owners due to not selling the shares at a the level of underpricing prevailing in the
higher price at the Initial Offering. This Colombo Stock Exchange after adjusting for
anomaly is also known as money left on the market changes. Hence the objectives are
table (Ritter, 2015). Investment banks also determined as,
play a major role in IPO
underpricing. Investment banks have the 1) Investigating the factors affecting IPO
incentive of providing high offer prices to the Raw Initial Return
issuer, leading to less underpricing and less 2) Examining the factors affecting on IPO
money on the table which in return helps the Market Adjusted Initial Return
bank grow their market shares in later periods 3) Inspecting the level of underpricing that
(Fung, Gul, & Hadhakrishnan, 2014). occurs in the CSE Scope
However, to gain higher fees investment
This study contributes to the limited literature
banks tend purposefully underprice as well.
available in Sri Lanka on Initial Public
All IPO issues are governed by the Securities
Offerings and related factors. Hence the
and Exchange Commission of Sri Lanka
paper is organized as related literature,
(SEC) which is the regulating body of stock
methodology, results, discussion,
market activities.
recommendation, and examining areas for
Even though there are lots of research studies future research.
conducted for developed markets, it is very
important to carry out research in developing Literature Review
markets as well in order to gain a clear idea
Theoretical View
of IPO underpricing anomaly and to verify
the contradictory views on the market. and Over the years various theories were
this contributes to current literature on IPOs, constructed by researchers in different
by evaluating the immediate return of IPOs, periods describing the underpricing anomaly.
factors that affect the initial return, and the
They are the Winners curse theory or
sectors that prevail high levels of
Adverse selection theory, random walk
underpricing providing investors with hypothesis, prospectus theory, The Principal-
meaningful insights on to base their Agent Theory, Lawsuit avoidance theory,
investment decisions.

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Insider retention theory, and Signaling effect Bansal and Khanna (2012) revealed that the
(Rock, 1986; Fama & F, 1965; Kahneman & Firm’s age, IPO years, book-building pricing
Tversky, 1979; Baron, 1952; Baron, 1982; mechanism, ownership Structure, issue size,
Ibbotson, 1975; Logue, 1973; Willenborg, & market capitalization significantly affect
1999; Karlis, 2000; Ellen, 2004). According the underpricing and the average level of
to the above theories, it has been found that underpricing was found to be 50%. Based on
higher the size of the investment bank, higher research conducted in Indonesia Stock
the demand for the IPO (signaling effect of Exchange, Mahatidana and Yunita (2017)
investment banks), higher the percentage of concluded that underwriter and auditor
shares owned by the insiders leads to an reputation processes have a negative
increase in the demand of the share price significant effect on the level of underpricing
resulting higher level of underpricing (insider and firm age, financial leverage, Return on
retention theory). According to the Lawsuit Assets (ROA), Net assets value (NAV) and
avoidance hypothesis, firms that are ownership concentration does not influence
subjected to higher litigation risks, the level of underpricing.
underprice their IPO issues more to reduce
the probability of being sued regarding the Herawati (2017) has considered ROA,
IPO. Current ratio, Debt to equity ratio (D/E),
Total asset turnover, and Earnings per share
Empirical View (EPS) as the financial factors and underwriter
reputation, auditor reputation, firm age, and
According to the empirical evidence on IPO firm size as the non-financial factors
underpricing and aftermarket performance, affecting on initial return, concluding that
Alberto Dell’Acqua (2015) has identified a non-financial factors do not influence initial
significant relationship based on the two tests returns. Betani and Asghari (2014) have
of the Row Initial Return (RIR) method and proved that the P/E ratio has a significant
the Market Adjusted Initial Return (MAIR) influence on the offer price.
method. Kanja (2014) has suggested that IPO
offer is an important determinant of initial With all the information gathered through
return based on the study undertaken in the theoretical and empirical views, this study
Nairobi securities exchange. As the factors improves substantially upon the analysis of
affecting IPO initial return and underpricing the level of underpricing in each industry
in the Sri Lankan context, Wijethunga (2016) sector while examining the factors affecting
has revealed that IPOs in the Sri Lankan initial return.
market are underpriced by 68% on Initial
Return (IR) and 72% on Market Adjusted Methodology
Average Abnormal Returns (MAAAR). It
was further observed that within seven days The study falls under the descriptive research
MAAAR is higher than one-month and three- category as it explains the factors that
month MAAAR. Moreover, it was revealed a influence an IPO’s initial return. The
higher percentage of IPO underpricing in population of the study is identified as all the
post-war periods in CSE. Samarakoon (2010) IPOs occurred during the past years in
identified that Sri Lankan IPOs are Colombo Stock Exchange. For this study,
underpriced by 34% and small issues are equity IPOs occurred in the first quarter from
more underpriced than large issues. 2006 to 2018 are considered to cover all the
Furthermore, he has stated that Investor sectors in the Colombo Stock Exchange.
sentiment or opinion is positively related to Relevant data are obtained from secondary
underpricing and affects small and large data sources precisely the CSE official
issues similarly. website, annual reports of the companies,
prospectors of IPOs, data CD issued by the

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Dias, D.S.M., Wijesinghe, M.R.P., Madhushani, P.W.G., KJM, 2023, 12 (01)

Colombo Stock Exchange, and IPO between age, EPS, Debt ratio, NAV, ROA,
application forms of the companies. P/E ratio, D/E ratio and RIR

According to the literature review, there are H2 = Assuming that all other factors are
three types of independent variables tested to controlled, there is a significant relationship
be influenced by Raw Initial Return (RIR) between age, EPS, Debt ratio, NAV, ROA,
and Market Adjusted Initial Return (MAIR). P/E ratio, D/E ratio and MAIR
They are Capital market variables, Entity
variables, and IPO variables (Kanja, 2014; H3 = Assuming that all other factors are
Wijethunga, 2016; Mahatidana & Yunita, controlled, there is a significant relationship
2017; Betani & Asghari, 2014; Bansal & between offer price, oversubscription rate,
Khanna, 2012). Based on this evidence, ASPI return, sector P/E and RIR
hypotheses are developed as well as the
conceptual framework is designed as follows. H4 = Assuming that all other factors are
controlled, there is no significant relationship
Developed Hypothesis between offer price, oversubscription rate,
ASPI return, sector P/E and MAIR
H1 = Assuming that all other factors are
controlled, there is a significant relationship

Conceptual Framework

Figure 01: The conceptual framework

Measurement of Variables Raw initial return was calculated using the

below equation
Raw Initial Return (RIR)

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Dias, D.S.M., Wijesinghe, M.R.P., Madhushani, P.W.G., KJM, 2023, 12 (01)

𝑃𝑖,1−𝑃𝑖,0 𝑀1−𝑀𝑜
𝑅𝑖 = ∗ 100 (1) 𝑀𝑅𝑡 = ∗ 100 (2)
𝑃𝑖,0 𝑀𝑜

Ri is the raw initial return of the security, Pi,1 MR is the market return, M1 is the closing
is the closing price of the share on the first price of the ASPI on the first trading day and
trading day and Pi,0 is the issues price of the M0 is the closing price of the ASPI at the end
stock. date of the subscribing period.

Market-adjusted Initial Return (MAIR) 𝑀𝐴𝐼𝑅𝑖 = 𝑅𝑖 − 𝑀𝑅 (3)

Market-adjusted initial return is calculated to Subsequently, MAIR was calculated by

account for the changes that occurred subtracting the market return from the raw
between the time lag of the end date of initial return.
subscribing period and the first trading date.
MAIR was calculated as follows.

Table 01: Measurement of variables

Independent Variable Description

All Share Price Index Return One-year ASPI return was calculated using ASPI return
(ASPI Return) at IPO date and ASPI return of one year before the IPO
date
Sector Price Earning (Sector Monthly sector P/E value was taken for each company.
P/E) i.e., the month of the IPO occurred.
Age Age of each company in years at the point of IPO issued
Earnings per Share (EPS) Calculated by dividing the earnings of each company by
the number of shares listed.
Debt Ratio Calculated by dividing each company's assets from debt
Net Assets Value (NAV) Calculated for each company by subtracting liabilities
from assets
Return on Assets (ROA) ROA is used as an overall measurement of company
profitability
Price Earning (P/E ratio) P/E ratio measures the current share price relative to its
earnings
Debt to Equity (D/E ratio) Calculated by dividing debt from the equity of the
company
Offer price Price offered by each IPO Company
Oversubscription rate The number of times shares were oversubscribed.
Source: Developed by the researcher

E-views is used to analyze the data set of the Covariance analysis is performed to identify
study and as the first step, regression analysis the relationship between the variables and to
is performed for both dependent variables measure the magnitude of the association
separately to identify the factors that are between the variables identified. Granger
significantly affected by RIR and MAIR. causality analysis is performed to identify the

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predictive power of the variables in other carried out to identify highly underpriced
words it confirms whether one variable can sectors in the Colombo Stock Exchange.
be used to predict the other variable
(predictive power of the variables). This is a Findings of the Study
two-way analysis. It tests whether dependent
variables can predict the independent Data analysis of the study consists of two
variables and whether the independent main stages: analysis of the factors affecting
variables can predict the dependent variables. RIR, MAIR, and underpricing analysis.
The level of underpricing that prevails in the Factors that are used to examine the effect on
Colombo Stock Exchange is measured by RIR and MAIR are analyzed under three
calculating the underpricing before and after main areas as Capital market variables, entity
removing the outliers from the model. variables, and IPO variables.
Finally, sector-wise underpricing analysis is

Table 02: Regression results applying Raw Initial Return (RIR) and Market Adjusted
Initial Return (MAIR)

Dependent Variables: RIR and MAIR

Method: Least Squares
RIR MAIR
Variable Coefficient Prob. Coefficient Prob.
Coefficient 0.182 0.281 0.431
Offer Price (OFFERP) -0.009 0.154 -0.013 0.0561*
All Share Price Index 0.258 0.0209** 0.213 0.0687*
Return (ASPIR)
Age -0.001 0.895 -0.002 0.741
Debt Ratio (DR) 0.055 0.765 0.151 0.440
Debt Equity Ratio (D/E) 0.012 0.412 0.017 0.270
Return on Assets (ROA) 0.000 0.984 0.004 0.543
Sector P/E (SECP/E) -0.002 0.475 -0.003 0.373
P/E Ratio 0.000 0.431 0.000 0.412
Net Assets Value (NAV) N/R N/R 0.001 0.265
Oversubscription Rate 0.005 0.152 0.006 0.0918*
(OSR)
Earnings Per Share (EPS) -0.007 0.506 -0.028 0.157
R-squared 0.417 0.427
Adjusted R-squared 0.259 0.252
F-statistic 2.644 2.441
Prob(F-statistic) 0.015** 0.022**
**Variables significant under 95% confidence level, * Significant variables under 90%
confidence level
Source: Survey Data

According to the Multiple regression analysis indicate that only ASPI return is significant
performed using RIR in table 02, results at 95% confidence level and all the other

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variables are being insignificant. NAV is The Model Developed based on MAIR
removed from the model due to the existence
of multicollinearity. The R squared value MAIR = 0.140553 -0.012OFFERP
represents the explanatory power of the +0.213ASPIR -0.002AGE +0.151DR
model and results outline a value of 41.7% +0.0166D/E +0.004ROA -0.003SECP/E -
indicating that 41.7% of the variation of the 0.000P/E 0.001NAV +0.006OSR -0.028EPS
initial return is explained by the explanatory
variables used in the model (Offer Price, When all the considered variables are at zero
ASPI return, age, debt ratio, D/E ratio, ROA, level, the IPO market-adjusted initial return
sector P/E, P/E ratio, oversubscription rate, is 14%. Furthermore, when ASPI Return is
EPS) and adjusted R squared value is 26% increased by 1%, the return is increased by
meaning all the variables considered in the 21% and when the debt ratio is increased by
model together explains the IPO 1%, the return is increased by 15%. These
underpricing approximately by 26%. Further two variables are the most influencing
the Results indicate that F statistics is variables as per the model.
significant under 95% confidence level.
Therefore, the overall model is significant, According to the developed two models,
and all the independent variables are jointly offer price and initial return are negatively
influenced on the dependent variable, or in related. ASPI return is also positively related
other words, the overall model is fitted. to the initial return, which shows that when
the market is performing well there is a high
According to the results based on MAIR in probability to generate a higher return since
table 02, ASPI Return, and the over- the ASPI is the most significant variable out
subscription rate are significant at a 90% of all the variables in the model. Since the
confidence level. All the other variables in company variables do not affect the initial
the model are insignificant (age, debt ratio, return even a financially strong company
debt to equity ratio, ROA, sector P/E, P/E may be overpriced on the first trading day
ratio, NAV, EPS). The R square value and on the other hand, even a company is not
indicates that the independent variables cover highly financially performing (ROA, Debt
the dependent variable by 42%. F statistic is Ratio, NAV, debt to equity ratio) company
significant under the 95% confidence level may generate higher initial return due to
proving the overall fitness of the variables to capital market favorability and IPO related
the model. Further, it confirms that all the factors. The oversubscription rate is also
independent variables are jointly influenced positively related to the initial return meaning
on the dependent variable. when there is a higher demand for the shares
inevitably initial return may go up. The age
Model Developed based on RIR of the IPO Company does not affect the
initial return of the company even a company
RIR = 0.1766 - 0.009OFFERP + that is in business for a small number of years
0.263ASPIR - 0.0016AGE + 0.055DR + may attain a higher return.
0.012 D/E + 0.001ROA - 0.0024SECP/E -
0.000PE +0.0004NAV +0.0048OSR - Diagnostic Tests of Regression Analysis
0.018EPS
According to the Durbin-Watson test statistic
Based on the developed model, as all received as 2.037, it was proven that the
considered variables are at zero level model is free from serial correlation. As per
exogenous IPO, RIR will be 17%. Moreover, the results of the correlogram of residuals
the most influencing variable of the model is test, all the probability values are
ASPI Return. When ASPI return is increased insignificant, proving that there is no serial
by 1% RIR will be increased by 26%. correlation exists in the data set. Even under

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the second test of the serial correlation, the Underpricing Analysis

Breusch-Godfrey Serial Correlation LM Test
due to the insignificant Chi-Square value of Underpricing occurs when the first-day
0.7266, no serial correlation is accepted. The trading price is high than the offer price.
Breusch-Pagan-Godfrey test is used to Some companies do this purposefully so their
examine the presence of Heteroscedasticity company shares may not be under
in the model, and test results outline that there subscribed. Hence underpricing can be
is no Heteroscedasticity due to the intentional as well as unintentional. Below
insignificant Chi-Square value of 0.3571. box plot graphs show the dispersion of
According to multicollinearity test results, underpricing occurred within the selected
the highest considerable percentages (78%) period. Before adjusting for outliers, level of
of multicollinearity is shown between EPS underpricing is RIR 22% and MAIR 18%.
and NAV, and the highest P value is given in
NAV. Therefore, that variable is eliminated
from regression analysis.

Figure 02: Box plot Graphs for RIR and MAIR before adjusting outliers

After adjusting for outliers, the level of removed the largest outliers from the model
underpricing in RIR is equal to 14% and since removing many outliers may lead to the
MAIR is 18%. The researcher has only manipulation of the model.

Figure 03: Box plot Graphs for RIR and MAIR after adjusting outlier

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Company Sector-wise Analysis

Table 04: Number of IPO’s occurred in each sector

Sector No of IPO’s
Hotels and Travels 5
Power & Energy 7
Land & Property 2
Manufacturing 3
Bank Finance and Insurance 16
Healthcare 1
Diversified Holding 6
Beverage Food and Tobacco 4
Construction And Engineering 1
Services 1
Footwear & Textiles 1
Information Technology 1
Source: Survey Data

From 2006 to 2018 first quarter, sixteen IPOs highest, and six IPOs from diversified
occurred from the banking, finance, and holdings. Only one IPO has occurred from
insurance sectors recording the highest sectors such as healthcare, construction and
number of IPOs and seven IPOs from the engineering, services, footwear and textiles,
power and energy sector being the second and information technology.

Underpricing in Each Sector

Table 05: Underpricing level in each sector

Sector Under Pricing

Hotels and Travels -0.00071
Power & Energy 0.14989
Land & Property 0.05000
Manufacturing -0.00636
Bank Finance and Insurance 0.29998
Healthcare 0.00000
Diversified Holding 0.05591
Beverage Food and Tobacco 0.49205
Construction And Engineering 0.05200
Services 1.25000
Footwear & Textiles 1.16667
Information Technology 0.00000
Source: Survey Data

Out of five companies, two companies in the overpriced, and in the manufacturing sector,
hotel and manufacturing sector are out of three companies only one company is

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overpriced, making the average result there is no impact from entity variables on the
overpriced in both sectors. The highest level initial return. Accordingly, objective one (1),
of underpricing exists in the footwear and which was to determine the factors that affect
textile sector at 1.167. However, this value is IPO initial return was satisfied. Therefore,
derived only based on one company (ODEL) the alternatives of hypotheses 02 and 04 are
hence it can’t be concluded that the highest accepted.
level of underpricing prevails in the footwear
and textile sector. The second highest value Discussion and Recommendation
is recorded in the services sector as 1.25
which also consisted of only one company Results of the study conclude that capital
hence concluding is futile. However, the next market variables (ASPI return), as well as
sector that gives the highest underpricing IPO variables (offer price over subscription
value is the beverage, food, and tobacco rate), have a significant influence on IPO.
sector which gives a value of 0.49205 The results found by Bansal and Khanna
containing four Initial Public Offerings and (2012) in their study is a supporting literature
none of the IPOs are overpriced. The next for the results generated. Somehow entity
significantly highest sector is the Bank variables do not have a significant influence
Finance and Insurance sector which has the on initial returns. Though most literature does
highest number of IPOs (16) within the not support this result generated, still
considered period. However, four companies supported the study undertaken by Herawati
out of these 16 companies are overpriced. (2017), studying the effect of financial and
non-financial factors on the initial return on
The power and energy sector has also the IPO companies in the Indonesia Stock
recorded a high level of underpricing at Exchange mentioned that non-financial
0.14989. The sector contains altogether factors such as underwriter reputation,
seven IPOs including one overpriced auditor reputation, firm age, and firm size do
company (Vallibel Power Erathna Ltd). not affect the initial return.
Under the diversified holding sector, the level When a company reduces the offer price, the
of underpricing is 0.0559. There are six IPOs initial return will increase and vice versa,
in this sector and a very important fact is this ASPI return is also positively related to the
sector contains two overpriced companies initial return, which shows that when the
namely Browns Investments and Softlogic market is performing well there is a high
Holdings and the overpricing is -0.04 and - probability to generate higher return since the
0.38 respectively. Here the -0.38 (Softlogic ASPI is the most significant variable out of
Holdings) can be considered as an outlier and all the variables in the model. Therefore, it is
if this value is removed from calculations recommended to investors look at the current
underpriced value increases up to 0.71 market return and make investment decisions
exceeding the beverage, food, and tobacco because it is vital for the initial return for the
sector. The remaining sectors namely land IPO return.
and property, health care, construction and
engineering, and information technology Since the company variables do not affect the
carry a very low level of underpriced values initial return even a financially strong
as 0.05000, 0.00000, 0.05200, and 0.00000 company may be overpriced on the first
respectively. trading day and on the other hand even a
company is not well financially performing
The overall results of the analysis conclude (ROA, Debt Ratio, NAV, debt to equity ratio)
that only capital market variables (ASPI company may generate higher initial return
return) and IPO variables (offer price over due to capital market favorability and IPO
subscription rate) affect the initial return and related factors.

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And also, when companies decide to go Insurance sector containing 4 and 16 IPOs
public, they should be concerned about the respectively which are recommended by the
timing of the IPO because ASPI return of the researcher for investment. Another focal
market will be highly affected by the money point is that in the diversified holding sector
left on the table. there is an outlier that contains a high level of
overpricing (Softlogic Holdings). Once the
The final objective of the study was to outlier is removed underprice value is
determine the level of underpricing that increased exceeding the beverage food and
occurs in the CSE and according to the tobacco sector value. So, it is recommended
results, raw initial return is 14%, and market that investors need to consider these factors
adjusted initial return is 18%. Under the when selecting a sector to invest in.
sector-wise underprice analysis footwear and
textile sector and service sector denoted the With the above recommendations, it is vital
highest level of underpricing, however, it is to discuss some limitations also. The main
not recommended these sectors as these limitation occurred in the study was the lack
sectors contained only one IPO from each of information in identifying the end date of
sector. the subscription period of some IPOs. The
secondary limitation of the study is not
Other sectors that consist of a high level of considering investor sentiment and factors
underpricing is the beverage food and such as hot market conditions and timing of
tobacco sector and Banking, Finance, and IPOs.

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