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5. Modigliani and Miller argue that the firm's value rises with leverage in the presence of corporate taxes. The diagram below illustrates this phenomenon. In your own words briefly explain the diagram and describe the theory. (15) Value of firm (V) Present value of tax shield on debt Maximum firm value V = Vy + t = Value of firm under MM with corporate taxes and debt Present value of financial distress costs V = Actual value of firm Vy= Value of firm with no debt -Debt (B) Optimal amount of debt Source: Ross, Westerfield, Jordan 6. The security market line (SML) is a line drawn on a chart that serves as a graphical representation of the capital asset pricing model (CAPM). a) Explain how a financial analyst can use SML curve to identify overvalued and undervalues assets? b) If a market is efficient and is in equilibrium, can assets plot above or below the SML ? Explain (15) Page 4 / 5 @ +