Assignment #4 Capital Structure Analysis

Chapter sixteen’s problem twenty-eight states the following:

“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 (Berk & DeMarzo, 2010).

a. 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

i. they know the correct value of the shares is $12.50?

Issue equity.

Borrowing has a net cost of $20 million. Selling at a premium of $1.00 per share has a benefit of $37 million. Therefore, managers should issue equity for $500 million.

Shares = Equity

$500 million = 37 million

Share price 13.50

Premium = $13.50 - $12.50 = $1.00

Benefit =

Shares

37 million = $37 million

Premium $1.00

ii. they know the correct value of the shares is $14.50?

Issue debt.

Borrowing has a net cost of $20 million. Selling at a discount of $1.00 per share has a cost of $37 million....