Analysts project that company X (currently all-equity financed) will have the following financial data depending on whether it is a good or a bad type (each type of firm is equally likely):

The growth opportunity consists of a positive NPV project with a required initial investment of $8,000 and a present value of $12,000. The cash on the firms balance sheet is for working capital purposes and cannot be used toward financing the project. Managers know with certainty whether the firm is a good or a bad type.

a) Suppose that you know that your company is good and you, as a manager, care only about the current shareholders. What would you do? What would you do if you know that your company is bad? Examine explicitly the following alternatives. a1) Do nothing

a2) Issue debt (Assume that issuing debt, due to potential distress costs, reduces the value of the issuer by $8,000 even if the firm does not default) a3) Issue equity

Hint 1: Notice that the firm has a highly profitable growth opportunity and the financial distress costs are quite high. In this case, the market is likely to expect that even good firms would issue equity (rather than passing up the project or issuing debt, which will generate financial distress costs). Hence, the market will price equity issues as coming from an average type (i.e., both good and bad firms are expected to issue equity).

Hint 2: In this question, the contingencies in which the firm may face financial distress or bankruptcy are not specified. Rather, if the firm uses debt, assume that the firm value will decline by $8,000 immediately.

b) Suppose that you know that your company is good and you, as a manager, care only about the current shareholders. What would you do? What would you do if you know that your company is bad? Examine the following alternatives.

a1) Do nothing

a2) Issue debt (Assume that issuing debt, due to potential distress costs, reduces the value of the issuer by $80 even if the firm does not default)

a3) Issue equity

Hint: Notice that the firm still has a highly profitable growth opportunity in this case, but the financial distress costs are quite small. In this case, the market is likely to expect good firms to finance the project by issuing debt rather than selling undervalued equity. Hence, the market will price equity issues as coming from the bad type.

c) Suppose the firm has 1,000 shares outstanding. Compute the change in the price of the shares if a firm does nothing or issues equity in the scenarios described in a) and b) and explain the difference. (In this part you do not need to examine what happens after the firm issues debt).

Hint: Assume that the timing of events is as follows. Before the firm makes any announcements, the market knows the information above, including the size of the financial distress costs, the fact that all the firms in the industry have the positive growth opportunity, and prices the equity of the firms before they decide what to issue accordingly. After the firms announce their intentions of "doing nothing," or "issuing equity" the market "reacts" and an adjustment in share price occurs. Find the change in share price when such a reaction occurs.

Value Type: Bad Good Cash $4,000 $4,000 8,000 Fixed asset value 12,000 4,000 Growth opportunity NPV 4,000