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CA Intermediate · Financial Management and Strategic Management · Financing Decisions - Capital Structure

According to the Modigliani-Miller (MM) hypothesis without taxes, the value of a levered firm is:

Under the Modigliani-Miller hypothesis without taxes, a levered firm has the same value as an otherwise identical unlevered firm. Value is determined by operating earnings and business risk, and arbitrage by investors eliminates any gain or loss from changing the capital structure.

  1. AHigher than that of an otherwise identical unlevered firm by the amount of debt
  2. BEqual to the value of an otherwise identical unlevered firmCorrect
  3. CLower than that of an otherwise identical unlevered firm because of financial risk
  4. DEqual to the value of its equity plus the book value of its preference capital only

Explanation

MM (without taxes) argues that firm value depends on the earning power and business risk of assets, not on the debt-equity mix. Arbitrage by investors removes any value difference between levered and unlevered firms. Options claiming higher or lower value reflect the traditional approach or tax-based MM, not the no-tax proposition.

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