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FRM Part II · FRM Exam Part II · Capital Structure in Banks

A bank's CFO argues that, because equity is more expensive than deposits and debt, the bank should lower its equity ratio to reduce its weighted average cost of capital and raise shareholder value. Under the Modigliani-Miller framework with no taxes, no bankruptcy costs and no safety-net subsidies, which statement best evaluates this argument?

Under Modigliani-Miller with no taxes, bankruptcy costs or subsidies, replacing equity with debt raises the equity holders' required return as leverage rises. This offsets the cheaper debt, so WACC and firm value do not change. The CFO's argument ignores the rise in the cost of equity.

  1. AThe argument is valid because debt is cheaper, so higher leverage lowers WACC and raises firm value.
  2. BThe argument is flawed because higher leverage raises the required return on equity, leaving WACC and firm value unchanged.Correct
  3. CThe argument is valid only if the bank is highly rated, since the cost of debt is then below the cost of equity.
  4. DThe argument is flawed because higher leverage lowers the cost of debt by enough to raise the cost of equity.

Explanation

In the MM world with no frictions, the firm's value and WACC are independent of capital structure. More debt makes equity riskier, so the required return on equity rises to offset the cheaper debt weight. The first option ignores this increase in equity cost.

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