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 belive that if IST borrows the $500 million, the present value of financial distress costs will exceed any tax benefits by 420 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 if 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 known, would managers choose to issue equity or borrow the $500 million if
i. they know the correct value of the shares is $12.50?
ii. they know the correct value of the shares is $14.50?
b. Given your answer to part (a), what should investors conclude if IST issues debt? What will happen to the share price?
c.Given your answer to part (a), what should investors conclude if IST issues debt? What will happen to the share price?
d. How would your answers change if there were no distress costs, but only tax benefits of leverage.
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