Question

4. Info Systems Technology (IST) manufactures microprocessor chips for use in appliances and other applications. IST has no debt and 50 million shares outstanding. The correct price for these shares is either $9 or $7 per share. Investors view both possibilities as equally likely, so the shares currently trade for $8. 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 $30 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 $8. 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 $7? ii. They know the correct value of the shares is $9?

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?

Answer 1

a).

Number of shares outstanding = 50 million

Correct price is either = 9 or 7

Current share price = 8

Amount needed = 450 million

Financial distress increase = 30 million

i. They know the correct value of the shares is $7?

Financial distress cost per share = Financial distress cost / No. of shares outstanding

= 30 million/50 million  = 0.60 per share.

Number of shares to be sold for raising amount = Amount needed / current stock price

= 450 million / 8 = 56.25 million shares

Firm is issuing at a premium of $1 per share.

Total Amount of benefit = (Premium amount * No of additional share )/(Current No. of shares outstanding + additional No. of shares issued)

= (1*56.25)/(50+56.25) = 0.53 per share

True Share price = (Correct share price * Number of shares outstanding +amount raised with equity)/(No. of shares outstanding + additional No. of shares issued)

= ((7* 50 million ) + 450 million) / (50 million + 56.25 million)

= 800 million / 106.25 = 7.53 per share , That is $7 + 0.53 . Therefore, issue equity to raise needed amount

ii. They know the correct value of the shares is $9?

Financial distress cost per share = Financial distress cost / No. of shares outstanding

= 30 million/50 million  = 0.60 per share.

Number of shares to be sold for raising amount = Amount needed / current stock price

= 450 million / 8 = 56.25 million shares

Firm is issuing at a discount of $1 per share.

Total Amount of cost = (discount amount * No of additional share )/(Current No. of shares outstanding + additional No. of shares issued)

= (1*56.25)/(50+56.25) = 0.53 per share

So cost = 0.53 per share.

True Share price = (Correct share price * Number of shares outstanding +amount raised with equity)/(No. of shares outstanding + additional No. of shares issued)

= ((9* 50 million ) + 450 million) / (50 million + 56.25 million)

= 900 million / 106.25 = 8.47 per share , That is $9 - 0.53 . Therefore, issue equity to raise needed amount

b) 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, then the investors would conclude IST as overpriced, and the share price will decline to $7.

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?

If IST issues debt, investors will conclude IST as undervalued, and the share price will rise to $9.