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The market values the assets of the firm Olaf as either $78 million in the high state (probability 0.25), $63 million in the medium state (probability 0.50), or $48 million in the low state (probability 0.25), depending on the success of the firms capital investment projects. The firm is financed entirely by equity.

Olafs CEO holds a large block of the firms shares. He knows that the intrinsic value of the firms 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 firms intrinsic value in each state.

The CEO plans to issue debt and use the cash to repurchase equity. In the event of financial distress, the loss of firm value would be $7 million.

Assume that the CEOs debt issue decision places equal weighting on the firms market price and intrinsic value. The market is semi-strong form efficient and there are no taxes.

1. Assume that the CEO can choose to issue debt with a face value of $55 million. What change will there be in the intrinsic value of the firms assets, if:

1. the CEOs valuation is correct?
2. the markets valuation is correct?

Will this debt issue give a credible signal to the market about the firms intrinsic value? Explain. (7 marks)

2. Rework your answers for (a), assuming now that the CEO can choose to issue debt with a face value of $65 million. (6 marks)

3. What conditions must hold for the debt signal to be effective? (120 words)

(5 marks)

To what extent can the debt signalling argument also apply to dividends? (180 words)

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