CFA Level I · CFA Level I Exam · Capital Structure
According to Modigliani and Miller Proposition I without taxes, a firm that increases its use of debt financing will most likely experience which of the following?
Firm value stays unchanged. In the no-tax Modigliani and Miller world, value is determined by operating cash flows and business risk, not by the financing mix. Added debt raises the cost of equity enough to offset debt's lower cost, leaving WACC constant.
- ANo change in firm valueCorrect
- BA decrease in the cost of equity only
- CAn increase in WACC due to cheaper debt
Explanation
Without taxes, firm value depends on the cash flows of assets and not on how they are financed, so value is unchanged. The cost of equity rises with leverage (Proposition II), offsetting cheaper debt, so WACC stays constant.
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