THE ROLES OF AUDITORS AND INVESTMENT BANKERS IN SIGNALLING PRIVATE INFORMATION AND INSURING LITIGATION RISK IN THE NEW EQUITY ISSUES MARKET (INITIAL OFFERINGS)

This dissertation examines how the entrepreneur of an initial public offering firm chooses the quality of the auditor and that of the investment banker under information asymmetry and litigation risk of being sued if the aftermarket price falls below the issue price. This study undertakes to bridge two problems that the entrepreneur faces, signaling his private information and mitigating the signaling cost. For that purpose, a model for the sequential choice of auditor and investment banker qualities, which have been studied separately in the literature, is developed.; Specifically, this study presents a scheme of penalty imposition by investors consistent with the legal environment of initial public offerings. Based on the penalty scheme, a model of sequential choice of auditor and investment banker qualities is constructed. In the model, the entrepreneur signals his firm value through the choice of auditor quality and reduces the signaling cost by hiring an investment banker of a certain quality to shift the risk of penalty imposition to the banker.; The basic implications of the model are: (1) market valuation of the firm is positively related to the auditor quality chosen; (2) the firm with high firm-specific variance chooses the low quality investment banker; (3) a positive association exists between auditor and investment banker qualities; and (4) the degree of effect of the auditor quality on the banker quality is negatively related to the level of firm-specific risk. The hypotheses developed in this study are empirically tested using regression analysis and other statistical tests. The sample for the empirical tests consists of firm commitment initial public offerings of common stock on NASDAQ during the 1986-1990 period. Overall, the empirical tests in this study support the proposed hypotheses.