Fin 534 Week 9 Assignment

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Date Submitted: 03/11/2011 10:33 AM

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Week 9 Assignment

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, managers believe that if IST borrows the $500 million, the present value of financial distress costs will exceed any tax benefits by $20 million. At the same time, because investors believe that managers know the correct share price, IST faces a lemons problem if it attempts to raise the $500 million by issuing equity.

Suppose that if IST issues equity, the share price will remain $13.50. To maximize the long term share price of the firm once its true value is known, would managers choose to issue equity or borrow the $500 million if they know the correct value of the shares is $12.50? Managers would choose equity because they gain $37 million. Because borrowing the $500 million will have a cost of $20 million or 20 / 100 = .20 cents per share. Selling $37 million shares at a premium of $1 per share has that $37 million benefit.

If the managers knew the correct value of the shares is $14.50 then hey would issue debt, because the 37 million shares at a discount of $1 is 37 million.

Given your answer to part (a), what should investors conclude if IST issues equity? What will happen to the share price? If IST issues equity, the investors would conclude that IST is overpriced and that the share price would decline to $12.50. However, if IST issues debt, investors will conclude that IST is undervalued and the share price would rise to $14.50.

Would the answer change if there were no...