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Asymmetric Information And Capital Structure Essay

734 words - 3 pages

Assignment 4

FIN 534

Rafael Diaz

Strayer University

08/25/2010

PROBLEM 28
ASYMMETRIC INFORMATION AND CAPITAL STRUCTURE
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 ...view middle of the document...

Question
b. Given your answer to part (a), what should investors conclude if IST issues equity? What will happen to the share price?
SOLUTION
Investors would conclude that the firm’s equity is overpriced. Investors are willing to pay less. Therefore, the stock price will decline. They will be more investors wanting to sell the stock.
Question
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?
SOLUTION
If the firm is willing to borrow the money instead of issuing equity, this most likely means that the value of the company’s stock is undervalued or underpriced. By wanting to borrow the money instead of issuing equity, the firm is also letting investors know that the company is doing well enough to be able to do this. They will believe that the company is doing good to finance its new production facility with debt.

Question
d. How would your answers change if there were no distress costs, but only tax benefits of leverage?
SOLUTION
I would say that if the share price is overpriced or...

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