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Optimistic Investors, IPOs Cycle and Real Investment

Abstract This paper studies the dynamics of the IPO (Initial Public Oﬀering) market and its eﬀect on real investment decisions in emerging industries. We ﬁrst propose a model of IPOs cycle based on divergence of opinion among investors and short-sale constraints. Using a real option approach, we show that ﬁrms are more likely to go public when the ratio of overvaluation over proﬁts is high, that is after stock market run-ups. Because initial returns increase with the demand from optimistic investors at the time of the oﬀer, the model provides an explanation for the observed positive causality between average initial returns and IPO volume. Second, we discuss the possibility of real overinvestment in new industries. Investing in the industry gives agents an option to sell the project on the stock market at an overvalued price. The IPO market enables then the ﬁnancing of positive NPV projects which would not be undertaken without overvaluation. It can however also lead to overinvestment in emerging industries.