John Rust, Georgetown University – University of Copenhagen

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John Rust, Georgetown University

"A simple Theory of Why and When Firms Go Public"

Abstract

We introduce a simple model of a public firm’s optimal investment, dividend, and debt policy to obtain a closed form solution for the value function and optimal investment and dividend payout decision functions in certain cases. We also characterize the optimal policy of a privately held firm and show how an owner’s desire to consumption smooth distorts its investment and dividend policy, resulting in a loss of market value relative to a publicly owned firm with a comparable level of capital and debt. We then consider the decision of the owner of a privately held firm to “take it public” via an initial public offering (IPO), that transforms the privately firm into a public firm with shareholders whose objective becomes maximization of its equity valuation in the stock market.

We characterize the conditions under which the owner of a private firm will want to undertake an IPO relative to other options (such as borrowing from a bank or investment of retained earnings, while keeping the firm private), and if the owner decides to undertake an IPO, how much of the IPO proceeds will the original owner “cash out”, how much of the proceeds will be reinvested in the firm, and how much of an ownership stake will the original owner retain in the newly formed public firm.

Keywords: IPOs, investment, finaincing decisions, dynamic programming
JEL classification: C13-15

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