Question

Info Systems Technology (IST) manufactures microprocessor chips for use appliances and other applications. IST has no debt and 125 million shares outstanding. The correct price for these shares is either $10.75 or $6.75 per share. Investors view both possibilities as equally likely, so the shares currently trade for $8.75. 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.

a. Suppose that if IST issues equity, the share price will remain at $8.75. 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 $6.75? ii. They know the correct value of the shares is $10.75?
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

To maximize long-term share price, managers would choose to issue equity if the correct value of the shares is $6.75 and borrow if the correct value is $10.75. Investors may conclude that the share price is overvalued if IST issues equity, and the share price may decrease. If IST issues debt, investors may conclude that the share price is undervalued, and the share price may increase. If there were no distress costs, but only tax benefits, the decision would depend on the tax benefits alone.

Step-by-step explanation:

To maximize the long-term share price of the firm once its true value is known, managers would choose to issue equity if they know the correct value of the shares is $6.75, and borrow if they know the correct value of the shares is $10.75.

If IST issues equity, investors should conclude that the true value of the shares is likely lower than the current share price of $8.75, which could lead to a decrease in the share price. If IST issues debt, investors should conclude that the true value of the shares is likely higher than the current share price, which could lead to an increase in the share price.

If there were no distress costs, but only tax benefits of leverage, the decision would solely depend on the tax benefits. Managers would choose to issue debt if the tax benefits outweigh the distress costs and maximize long-term share price.