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

According to the Modigliani-Miller (MM) proposition without taxes, which of the following statements about a firm's value is correct?

Under the Modigliani-Miller proposition without taxes, firm value does not depend on the debt-equity mix. Cheaper debt is exactly offset by a higher cost of equity, so the weighted average cost of capital and total value remain unchanged at every leverage level.

  1. AFirm value is independent of the debt-equity mixCorrect
  2. BFirm value rises steadily as more debt is added
  3. CFirm value falls steadily as more debt is added
  4. DFirm value is highest when the firm is fully equity financed

Explanation

MM without taxes assumes perfect capital markets and no taxes. Any benefit from cheaper debt is exactly offset by a rise in the cost of equity, so the overall cost of capital and firm value stay constant. Options claiming value changes with leverage belong to the Net Income or traditional views.

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