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Asymmetric Information And Capital Structure

Info System Technology (IST) manufacturers microprocessor chips for an 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 share currently trade for $13.50.

ITS must raise $500 million to build a new production facility. Because the firm would suffer a large lost of both customers and engineering talent in the event of financial distress, managers believe that if IST borrows the $500, 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 IST issues equity, the share price will remain $13.50. To maximize the long-term share price of the firm once its true value is know, would managers choose to issue equity or borrow the $500 million if:
i) They know the correct value of the share is $12.50?
ii) They know the correct value of the share is $14.50?

b. Given your answer to part (a), what should investors conclude if IST issue equity? What will happen to the share price?

c. Given your answer to part (a), what should investors conclude if IST issue debt? What will happen to the share case?

d. How would your answer change if there were no distress costs, but only taxes benefits of leverage?

Solution Preview

Question a, i)
Given a correct valuation of $12.50 as compared to the current trading price of $13.50, IST's common stocks are overvalued in the stock exchange, then managers would choose to issue equity to raise the necessary $500 million funding for the new production facility. This strategy takes advantage of the overvaluation of the company's stocks. An overvalued stock results to the issuance of a lesser number of shares compared to the situation if it's correctly valued.

Question a, ii)
On the other hand, if the correct value is $14.50 compared ...

Solution Summary

The solution is comprised of a detailed discussion on asymmetric information and capital structure.

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