Suppose a firm Material Precisions is considering starting a new project, which requires financing of £5 million. The firm has not sufficient internal reserves now, so it is looking into either issues of new shares or bonds. The firm’s share price is currently £10 per share with 1 million shares outstanding, and has a debt of £7 million. The firm’s management estimates that increase in the costs of financial distress due to an increase in leverage is the same as that in the present value of tax shield when the firm’s debtequity ratio is 1.2.
a) Suppose that the predictions of the pecking order theory hold.
i) Which financing method should the firm prioritise – equity or debt? [10 marks]
ii) If we describe the situation as a Principal-Agent model, what party is the Principal? What party is the Agent? What is the asymmetric information in the model? [10 marks]
iii) If the firm chooses to issue new equity, what will most likely happen to the share price? Explain briefly why by focussing on the informational asymmetry. [10 marks]
iv) Describe the Principal-Agent model of this situation as a signalling game. You may draw a game tree as shown in the lecture (no need to describe payoffs). [10 marks]
b) Suppose instead that the predictions of the trade-off theory hold, how should the firm finance the project? Explain briefly why.