Dianetta B. Fayall
Assignment #4: Capital Structure Analysis
Corporate Finance: The Core
Dr. William Cheng
August 27, 2011
What is Capital Structure Capital structure is when a company starts considering its proportion of short and long- term debt. This process is normally referred to as a capital structure and sometimes called debt-to-equity ratio, which gives an organization an outlook on how risky a business is. This analysis weighs heavily on an organization finances. Usually a company more heavily financed by debt poses? greater risk, as this firm is relatively highly levered (Investopedia, 2011).
This report is about ???Capital Structure Analysis???, and how??? it depends on market imperfections, such as taxes, financial distress costs, agency costs, and asymmetric information???. (Berk & DeMarzo 2010, p.541) This report will also discuss Leverage and the risk of default. Capital Structure also provides an organization with helpful analysis of for Long-term decisions, large expenditures and is very important to an organizations future. ???With perfect capital markets, a firm??™s security choice alters the risk of the firm??™s equity, but it does not change its value or the amount it can raise from outside investors??? (Berk & DeMarzo 2010, p.541). These decisions can affect a company??™s revenue and cost. Taxes are considered to be the most significant imperfection that drives a capital structure. Most organizations uses leverage to shield and protect its income from taxes. ???An organization with greater leverage is considered to be highly recommended competitor and is persistent to protect its market with limited risks of bankruptcy??? (Berk & DeMarzo 2010, p.531). This assignment focuses on Info Systems Technology. Info Systems Technology manufactures microprocessor chips for use in appliances and other applications. This problem shows how important Capital Structure is to an organization when determining which projects or investments an organization should take.
Chapter 16: Problem# 28
Info 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 shares 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) 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
Managers would choose to issue equity because they know that the correct value of shares is $12.50 and they would be borrowing $0.20 per share and selling 37 million shares at a premium of $1 per share. This would cause them to gain $0.27 per share. 20/100 = $.20, 500/13.50 = 37M shares, 37/137 = $0.27 per share. (12.50 x 100 + 500 / 100 + 500/ 13.50 = 12.77 = 12.50 + 0.27).
ii) They know the correct value of the shares is $14.50
Managers would choose to issue debt for this problem. The only difference would be that they would be selling shares at a discount. $20/100 = $0.20 per share, selling 500/13.50 = 37 million shares at a discount of $1 per share has a cost of $37 million or 37/137 = $0.27 per share. (14.50 x 100 + 500 /100 + 500/13.50 = 14.77 = 14.50 + 0.27).
b) Given your answer to part (a), what should investors conclude if IST issues equity What will happen to the share price
If the equity of IST is given out their investors would make a decision that IST is overpriced and the share price would decline to $12.50. The market will decline and new investors would look over IST at some point.
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
If the debt of IST is given out their investors would make the decision that IST is undervalued and the share price would rise to $14.50. The current investors will buy more stock and there will be an increase of new investors for this company.
d) How would your answers change if there were no distress costs, but only tax benefits of leverage
Because of no distress cost and only tax benefits of leverage equity would only be issued if it is overpriced. Knowing this, investors would only buy equity at the lowest possible value for the firm. There would be no benefit to issuing equity; all the firms would issue debt. Investors will only buy a limited amount of shares when it is overpriced.
Berk, J. & DeMarzo, P. (2010) Corporate Finance: The Core. Prentice Hall, Upper Saddle River,