Question

P16-31 (similar to) Info Systems Technology​ (IST) manufactures microprocessor chips for use in appliances and other applications. IST has no debt and 200 million shares outstanding. The correct price for these shares is either $ 15.25 or $ 11.25 per share. Investors view both possibilities as equally​ likely, so the shares currently trade for $ 13.25 . IST must raise $ 550 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 $ 550 ​million, the present value of financial distress costs will exceed any tax benefits by $ 15 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 $ 550 million by issuing equity. a. Suppose that if IST issues​ equity, the share price will remain $ 13.25 . 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 $ 550 million if i. They know the correct value of the shares is $ 11.25 ​? ii. They know the correct value of the shares is $ 15.25 ​? 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?

Answer 1

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