Capital structure analysis - Math Problem Example

Since the managers are not sure of the accurate share price IST, the company would face a lemons problem if it would wish to raise the amount of capital required through issuing equity. A lemons problem takes place when both the buyers as well as the sellers have asymmetric information about the worth of the product in order to take an informed choice, and it is not possible to get hold of the correct information. For example, if in the market, the buyer cannot determine the value or worth of the product precisely, then he might be willing to pay only an average price for it, which is near about the mean value of the bid price and the offer price.

But, this skews the balance towards the lemon seller (whose products are not of high quality), because receiving an average price for his low quality product is good enough for him; as the average price would definitely be higher than the price the product would command if the buyer knew in advance about the quality of the product. This occurrence also places the seller of a good quality product in a disadvantageous position, since the best value such a seller can anticipate to get for his product is an average price, which is actually lower than the value the product should command (Tel Aviv University, n.d.). Prob. a) In the case of IST, since the managers of IST are not sure about the accurate price of these shares and feel that it is either $12.5 or $14.5, so as the investors have chosen an average price and hence the shares of IST are presently trading at $ 13.50. i) At present, if the company issues equity to raise the required capital, the share price will remain $13.5. The managers of IST would always want to maximize the long-term share price of the company.

If the managers know that the accurate value of the share is $12.5; because the shares would be priced at $13.5 which is higher than the actual correct price, the company will have to issue comparatively lesser number to shares as compared to the situation if the shares were priced at $12.5. If the share price was $12.5, IST would have to issue 40 million shares to raise $500 million and now that the share is trading at $13.5, it will have to issue 37.037 million shares. Thus, since in this case IST has to issue 2.

96 million less shares, it gains around $40 million (2.96 million times 13.5) and hence the managers would definitely choose to issue equity to raise $500 million ii) But, if the managers know that the accurate value of the shares is $14.5, issuing equity would mean that the share price would remain at $13.5 though its actual value is more. This would go against their policy to maximize the long-term share price of the company and would also imply that the company would have to issue 2.55 million more shares than it would have at share price of $14.5. This would lead to a loss of $34.

42 million (2.55 million times 13.5). If the company borrows the required amount, it has a threat of potential financial distress and the present value of the financial distress cost would be more than any tax benefit, by at least $20 million. The potential loss by issuing debt is much less than the loss by issuing equity, hence in this case the mangers would choose to borrow $500 million instead of issuing equity. Prob. b) If the management of IST issues equity, then the investors should conclude that the