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 $15.75 or $13.75 per share. Investors view both possibilities as equally likely, so the shares currently trade for $14.75. 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 $10 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 at $14.75. To maximize the long-term share price of the firm once its true value is known, should managers choose to issue equity or to borrow the $550 million under the following conditions: i. If they know that the correct value of the shares is $13.75? O Managers should borrow the $550 million. O Managers should issue equity for $550 million. ii. If they know that the correct value of the shares is $15.75? O Managers should borrow the $550 million.
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 $15.75 or $13.75 per share. Investors view both possibilities as equally likely, so the shares currently trade for $14.75. 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 $10 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 at $14.75. To maximize the long-term share price of the firm once its true value is known, should managers choose to issue equity or to borrow the $550 million under the following conditions: i. If they know that the correct value of the shares is $13.75? O Managers should borrow the $550 million. O Managers should issue equity for $550 million. ii. If they know that the correct value of the shares is $15.75? O Managers should borrow the $550 million.
Chapter7: Valuation Of Stocks And Corporations
Section: Chapter Questions
Problem 1lM
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Transcribed Image Text: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 $15.75 or $13.75 per share. Investors view both possibilities as equally likely, so the shares currently trade for $14.75.
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 $10 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 at $14.75. To maximize the long-term share price of the firm once its true value is known, should
managers choose to issue equity or to borrow the $550 million under the following conditions:
i. If they know that the correct value of the shares is $13.75?
Managers should borrow the $550 million.
Managers should issue equity for $550 million.
ii. If they know that the correct value of the shares is $15.75?
Managers should borrow the $550 million.
Managers should issue equity for $550 million.
b. Given your answer to part (a), what should investors conclude if IST issues equity, and what will happen to the share price?
O A. If IST issues equity, investors would conclude IST is underpriced and the share price would rise.
O B. If IST issues equity, investors would conclude IST is overpriced and the share price would decline.
c. Given your answer to part (a), what should investors conclude if IST issues debt, and what will happen to the share price in that case?
A. If IST issues debt, investors would conclude IST is overvalued and the share price would decline.
O B. If IST issues debt, investors would conclude IST is undervalued and the share price would rise.
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