Skip to content

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 replace equity funding with debt to lower its weighted average cost of capital and raise shareholder value. Under the Modigliani-Miller framework without taxes, bankruptcy costs or frictions, which statement is most accurate?

Under Modigliani-Miller without frictions, firm value and WACC do not change with leverage, because the cost of equity rises as debt increases and exactly offsets the cheaper debt. Replacing equity with debt just shifts risk to shareholders and creates no value.

  1. ATotal firm value is unchanged by the debt-equity mix because the required return on equity rises as leverage increases, offsetting the cheaper debtCorrect
  2. BFirm value rises with leverage because debt has a lower required return than equity and WACC falls continuously
  3. CFirm value falls with leverage because the cost of debt rises faster than the cost of equity
  4. DThe required return on equity stays constant as leverage rises, so only the debt share affects WACC

Explanation

In MM without frictions, the cost of equity increases linearly with the debt-to-equity ratio, exactly offsetting the substitution of cheaper debt. WACC and firm value are therefore unchanged. The CFO's view ignores the increased risk borne by equity holders.

Did you get it right without looking?

One question tells you little. A timed set on Capital Structure in Banks shows your real accuracy, how long you take and where you lose marks.

Practise Capital Structure in BanksFree diagnostic mock

More Capital Structure in Banks questions