June 4, 2011
Info Systems Technology (IST) manufactures microprocessor chips for use in appliances and other applications. IST has no debt and 100 million shares outstanding. The correct price for these shares is either $14.50 or $12.50 per share. Investors view both possibilities as equally likely, so the shares currently trade for $13.50.
IST must raise $500 million to build a new production facility. Because the firm would suffer a large loss of both customers and engineering talent in the event of financial distress costs will exceed any tax benefit by $20 million. At the same time, because investors believe that managers know the correct share, IST faces a lemons problem if it attempts to ...view middle of the document...
Issuing equity (500/13.50) = 37 million. 37/137 = .27 per share. But they can sell the shares for 1.00. Selling or issuing equity will benefit the firm by 37 million. The firm should issue equity.
12.50*100 + 500 / 100 + 500/ 13.50 = 1750/137.04 = 12.77.
ii. They know the correct value of the shares is $14.50
If the correct value of the shares is 14.50 then the firm should issue debt because if they borrow debt, it will have a cost of 20 million which is .20 per share and issuing equity will be about .27 a share.
b. Given your answers to part (a), what should investors conclude if IST issues equity? What will happen to the share price?
iii. I think that if the firm issues equity then most of the people interested in the firm will probably not want to invest in it because the shares would be over priced or to costly and I think as a result of that and the loss of interest of investors will drive the price back down to 12.50.
c. Given your answers to part (a), what should investors conclude if IST issues debt? What will happen to the share price in that case?
iv. I think the opposite will happen if the firm issues debt. I think the investors will feel that the stock is undervalued and the price will go up to 14.50.
d. How would your answers change if there were no distress costs, but only tax benefits of leverage? If there are only tax benefits of leverage and no distress costs then I feel that the firm would be placed between a rock and a hard place. The firm would only try to issue equity but the equity would be over-valued and as a result the investors will not buy it because it would not make financial sense. So the firm would then want to issue debt because there are no costs associated with issuing the debt.