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Capital Asset Pricing Model (CAPM) E(R, )= R, + B, E(R. )-R, ] Modigliani and Miller Proposition I (no tax): V1 = Vu Proposition II (no tax): R = R. +(R. -R. ) Proposition I (with corporate tax): V, = V, + ID Proposition II (with corporate tax): R = R. + (R. - R. [1-I.) Miller (1977) VI =V + 1- (1- 7 1 - I. ) D 1-IThe mantet values the assets of the rm Olaf as either $78 million in the 'high' state (probability 0.25). $63 million in the 'medium' state (probability.r 0.50), or $48 million in the 'lovv' state (probability 0.25), depending on the success of the lion's capital investment projects. The rm is nanced entirely by equity. Olaf s CEO holds a large block of the rm's shares. He knows that the intrinsic value of the rm's assets is either $83 million in the 'high' state {probability 0.25}, $68 million in the 'medium' state (probability 0.50), or $53 million in the 'low' state (probability 0.25}. The market is aware that the CEO Knows the rm's intrinsic value in each state. Page 5 of a UL21EDDTT \"J C} d} The CEO plans to issue debt and use the cash to repurchase equity. In the event of nancial distress. the loss of rm value would be $T million. Assume that the CEO's debt issue decision places equal weighting on the rm's market price and intrinsic value. The market is semistrong form efcient and there are no taxes. Assume that the CEO can choose to issue debt with a lace value ot $55 million. What change will there be in the intrinsic value ot the lion's assets, it (i) the CEO's valuation is correct? {ii} the market's valuation is correct? Will this debt issue give a credible signal to the market about the rm's intrinsic value? Explain. [7 marks} Rewom your answers tor (a), assuming now that the CEO can choose to issue debt with a face value 0? $55 million. {6 marks) What conditions must hold for the debt signal to be eective? (120 words) {5 marks} To what extent can the debt signalling argument also apply to dividends? {1'80 words) {7 marks)