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

According to the Modigliani-Miller (MM) proposition without taxes, the value of a levered firm compared with an otherwise identical unlevered firm is:

Under the MM proposition without taxes, the value of a levered firm equals that of an unlevered firm. Cheaper debt is offset by a higher cost of equity, so the weighted average cost of capital and total firm value are independent of capital structure.

  1. AHigher, because debt is cheaper than equity
  2. BLower, because debt increases financial risk
  3. CEqual, because the capital structure does not affect firm valueCorrect
  4. DHigher by the present value of interest paid

Explanation

MM without taxes assumes perfect markets, so cheaper debt is exactly offset by a rise in the cost of equity. Overall cost of capital and firm value stay unchanged whatever the debt-equity mix. Options A and D describe the MM-with-taxes or traditional view, not the no-tax proposition.

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