3-page Report on Problem 28 pages with conclusions and show calculations - Essay Example

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 If there are no costs from issuing debt, then the managers would only issue equity if the correct value shares are overvalued.

But because of this, investors would only buy equity at the lowest possible value for the firm, which in this case is $12.50 and not $13.50. Since there would be no gains by issuing equity, the firm would issue debt. The key to the decision of the managers on whether to borrow or issue equity lies with the accuracy of the information that they have. In the two cases we analyzed, if the value of shares is actually lower than the current share price (it is overvalued), it would make sense for the managers to issue equity, knowing that investors will respond in such a way that the price will just eventually go down to the actual value of the shares.

However, if the actual value turns out to be higher (it is undervalued), borrowing shows that the company thinks (or knows) this is so and will prompt investors to raise share prices eventually matching the value that the managers want it to reach. This phenomenon says a lot about how information about the actual value of a stock versus speculative pricing affects the market. Investors respond to choices made by companies based on assumptions like the ones we illustrated, whether or not managers are educated enough to know that the market will move that way.

In this, we see that reckless borrowing or selling leads to undesirable results for managers. In the same way, managers who have deft control of