Info Systems Technology (IST) manufactures microprocessor chips for use in appliances and other applications. IST has no debt and

125

million shares outstanding. The correct price for these shares is either

$10.50

or

$6.50

per share. Investors view both possibilities as equally likely, so the shares currently trade for

$8.50.

IST must raise

$400

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

$400

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

$400

million by issuing equity.

a. Suppose that if IST issues equity, the share price will remain

$8.50.

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

$400

million if

i. They know the correct value of the shares is

$6.50?

(Select the best choice below.)

Managers should issue equity for

$400

million.

Managers should borrow the

$400

million.

ii. they know the correct value of the shares is

$10.50?

(Select the best choice below.)

Managers should issue equity for

$400

million.

Managers should borrow the

$400

million.

b. Given your answer to part

(a),

what should investors conclude if IST issues equity? What will happen to the share price?

(Select the best choice below.)

A.If IST issues equity, investors would conclude IST is underpriced, and the share price would rise to

$8.50.

B.If IST issues equity, investors would conclude IST is overpriced, and the share price would decline to

$6.50.

C.If IST issues equity, investors would conclude IST is overpriced, and the share price would decline to

$8.50.

D.If IST issues equity, investors would conclude IST is underpriced, and the share price would rise to

$10.50.

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?(Select the best choice below.)

A.If IST issues debt, investors would conclude IST is overvalued, and the share price would decline to

$10.42.

B.If IST issues debt, investors would conclude IST is undervalued, and the share price would rise to

$8.50.

C.If IST issues debt, investors would conclude IST is undervalued, and the share price would rise to

$10.42.

D.If IST issues debt, investors would conclude IST is overvalued, and the share price would decline to

$8.50.

d. How would your answers change if there were no distress costs, but only tax benefits of leverage?(Select the best choice below.)

A.All firms would issue debt, and the share price would fall below

$8.50

on the announcement.

B.All firms would issue debt, and the share price would rise above

$8.50

on the announcement.

C.All firms would issue equity at a share price of

$8.50.

D.All firms would issue equity at a share price of

$6.50.

E.

There would be no change from the answers above.