Capital structure is a term used to refer to the fraction of debt and equity that make up a firm’s total capital. The cost of debt is the amount above the borrowed amount that lenders demand from the firm in form of interest.
There are benefits associated with each financing criteria. For instance, using debt to finance a project qualifies a firm for an interest tax shield. This means that, interest paid for debt is deducted from taxable income which serves to reduce the cost of financing as opposed to equity financing. The expenses incurred in issuing debt are fewer and the managers are pressured to allocate the funds to more profitable projects in a bid to protect their careers. However, using debt has a disadvantage of pushing the firm into financial distress by incurring extra costs to service the debt when the firm is experiencing tough financial times (Parrino, R. & Kidwell, D. S., 2009).
28 a). Assuming that the share price of IST will remain $13.50 after issuing equity and that:
i) The managers know the correct value of the shares is $12.50,
The firm needs $500 million to finance the project. If equity is issued to obtain the funds, then 37 million shares must be issued:
$500 million / $13.50 = 37 m.
However, the share price of $13.50 is inclusive of a $1 premium, therefore the total benefit to the firm due to share premium is 37m x $1 = $37 m. This is equivalent to $ 0.27 per share. This can be shown as,
12.50 x 100 + 500 = 12.77
100 + (500 /13.50)
The par value is $ 12.50, 12.77 – 12.50 = 0.27, which is the premium per share.
The borrowing cost is $20 m and the firm will compare the $20m borrowing cost with the $37 m benefit accruing from share issue at a premium.
The best choice is to issue shares to maximize on the premium benefit.
ii) The managers know the correct value of shares is $14.50,
This means that if the shares are issued at $13.50, buyers will buy at a discount of $1. The total discount, which is a cost of equity financing to the firm will be $37 m. This cost is greater than the $20 m cost of borrowing. Alternatively, the debt cost per outstanding share of $0.20 can be compared with the $0.37 discount per share, (37/137) = $0.27 which is a higher cost. In this case, the managers will finance the project through debt issue since it is cheaper than share issue.
b) & c) Effects of the lemon problem
That IST is facing a lemon problem is common in the market especially at the stock market. This is a situation where both the seller and the buyer have access to asymmetric...