IntroductionCapital structure is a term used to refer to the fraction of debt and equity that makes up the total capital of a firm. The cost of debt is the amount above the borrowed amount that lenders demand from the business in the form of interest. There are benefits associated with each financing criterion. For example, using debt to finance a project qualifies a business for an interest tax shield. This means that the interest paid on the debt is deducted from your taxable income, which serves to reduce the cost of financing compared to equity financing. The costs incurred to issue debt are lower and managers are pressured to allocate the funds to more profitable projects in an attempt to protect their careers. However, the use of debt has the disadvantage of pushing the firm into financial difficulty by incurring additional costs to service the debt when the firm experiences difficult financial times (Parrino, R. & Kidwell, D.S., 2009).28 a). Assuming that IST's share price remains $13.50 after the share issue and that: i) Managers know that the correct value of the shares is $12.50, the company needs $500 million to finance the project. If shares are issued to obtain the funds, then 37 million shares must be issued: $500 million / $13.50 = 37 million. However, the stock price of $13.50 is inclusive of a $1 premium, so the total benefit to the company from the stock premium is 37 million x $1 = $37 million. This equates to $0.27 per share. This can be shown as: 12.50 x 100 + 500 = 12.77100 + (500 /13.50) The face value is $12.50, 12.77 – 12.50 = 0.27, which is the premium per share. The cost of borrowing is $20 million, and the firm will compare the cost of borrowing $20 million to the benefit of $37 million from issuing shares at a premium. The best choice is... middle of paper... an advantage and managers would prefer it to debt financing. If the cost of borrowing is zero and shares can only be issued at a discount, managers will issue debt to avoid the additional cost of equity financing. However, investors try to maximize their monetary value by purchasing shares at the lowest possible price the company is willing to offer. With no benefit accruing from equity financing, managers will use debt issuance since it has no cost (Berk & Demarzo 2011). ReferencesBerk & Demarzo, 2011. P. 213-214. Financial Distress, Managerial Incentives, and Information… Pearson Education, Inc. Publishing Ricardo N. Bebczuk, 2003. P. 37-52 Asymmetric Information in Financial Markets: Introduction and Applications. Cambridge University Press.Xin Chang et al, 2011. P. 7. Capital Structurehttp://www.bm.ust.hk/fina/staff/Dasgupta/Chang_Dasgupta_Hilary.pdf)