Info Systems Technology (IST) manufactures microprocessor chips
for use in appliances and other applications. IST has no debt
and100million shares outstanding. The correct price for these
shares is either $13.50 or $11.50 per share. Investors view both
possibilities as equally likely, so the shares currently trade for
$12.50. IST must raise $450 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 $450 million,
the present value of financial distress costs will exceed any tax
benefits by $25 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 $450 million by issuing
equity.
a. Suppose that if IST issues equity, the share price will
remain $12.50.
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 $450 million if
i. They know the correct value of the shares is $11.50?
ii. They know the correct value of the shares is $13.50?
b. Given your answer to part (a), what should investors
conclude if IST issues equity? What will happen to the share
price?
c. Given your answer to part (a), what should investors
conclude if IST issues debt? What will happen to the share price
in that case?
d. How would your answers change if there were no distress
costs, but only tax benefits of leverage?
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