Asymmetric Information and Capital Structure

Asymmetric Information and Capital Structure

Information 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 share 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 the $500 million, 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. If IST issues equity the share price will remain $13.50 a share, 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 $500 million if they know the correct value of the shares is $12.50 a share. This would equal 1 billion, 250 million dollars. ($12.50 x 100 million shares = 1,250,000,000)

If the correct value of the shares is $14.50 a share. This would equal 1 billion, 450 million dollars. ($14.50 x 100 million shares = 1,450,000,000)

b. The share price will go down, possibly lower than $12.50 a share if IST issues equity.

c. If IST issues debt, the share price can stay the same and the company has extra tax benefits.

d. The answers would not change, it would just make it more feasible to borrow the money.

Managers would choose to borrow the $500 million because of the debt tax shield and because it would give them more control over their company rather than issuing equity because if they issue equity, they can't control the cost of the shares, it might drop below the current possibility of $12.50 per share and also, they would possibly have someone come in and buy out the company by buying up large quantities of shares to get a majority of the shares. Of course, they would also face the possibility of losing control of the company if they didn't pay (weren't able to pay) the debt payments, but the gamble would be slight, due to the variables. Future debt payments would be known and could be planned for. The interest payments for the debt can be taken off taxable income and so a company that is in a higher tax bracket could save a substantial amount in lower taxes. This could possibly cause a smaller cash-flow, which could work in the company's favor and make production tighter with less overage.