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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 statement is correct about the value of a firm?

Under MM without taxes, a firm's value is independent of its capital structure in a perfect market. Value depends on operating earnings and business risk, so changing the debt-equity mix does not create or destroy value, since cheaper debt is offset by higher cost of equity.

  1. AValue of a levered firm exceeds that of an unlevered firm by the debt amount
  2. BValue of a firm is independent of its capital structure in a perfect marketCorrect
  3. CValue of a firm falls steadily as debt rises
  4. DValue of a firm is maximised at 100% debt

Explanation

MM's proposition without taxes assumes perfect capital markets, no taxes and no transaction costs. Under these assumptions the firm's value depends on its operating earnings and business risk, not on the debt-equity mix. The first option describes a tax-based result, not the no-tax case.

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