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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, the bank should replace equity with deposits to lower its weighted average cost of capital and raise firm value. Which response best reflects the Modigliani-Miller logic as applied to banks?

With no frictions, Modigliani-Miller says funding mix does not change firm value. More deposits make equity riskier, so the required return on equity rises and offsets the cheaper debt, leaving the overall cost of capital unchanged. The CFO's claim ignores this offset.

  1. AThe argument is correct because debt is always cheaper than equity at any leverage level
  2. BIn a frictionless setting, higher leverage raises the required return on equity, so the overall cost of capital is unchangedCorrect
  3. CReplacing equity with deposits lowers the cost of equity because deposits are insured
  4. DLeverage has no effect on equity risk, so the cost of equity stays constant

Explanation

Under MM without frictions, cheaper debt is offset by a higher required return on equity as leverage raises equity risk, so the WACC and firm value do not change. The CFO ignores this offset. Deposit insurance and tax shields are frictions that can alter the result, but they are not part of the base proposition.

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