Canalot plc is an all equity company with an equilibrium market value of 32.5m and a cost of capital of 18%.

The company proposes to repurchase 5m of equity and replace it with 13% irredeemable loan stock.

Canalot's earnings before interest and tax are expected to be constant for the foreseeable future. Corporate tax is 35%. All profits are paid out as dividends.

Required

Using the assumptions of Modigliani and Miller explain and demonstrate how this change in capital structure will affect:

(i) the market value; (ii) the cost of equity; and (iii) the cost of capital

of Canalot plc.