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IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy

Under Modigliani and Miller's Proposition I (no taxes, no bankruptcy costs, perfect capital markets), which statement about the value of a firm is correct?

Without taxes or bankruptcy costs, firm value is independent of capital structure. It is set by the cash flows from the firm's assets and investment decisions, so changing the debt-equity mix only redistributes those flows between investors without changing total value.

  1. AFirm value rises steadily as the proportion of debt in the capital structure increases
  2. BFirm value depends on the investment decisions and cash flows of the firm, not on how it is financedCorrect
  3. CFirm value is highest when the firm pays out all earnings as dividends
  4. DFirm value falls as debt increases because the cost of debt exceeds the cost of equity
  5. Firm value is maximised at a debt-to-equity ratio equal to one

Explanation

MM Proposition I without taxes says the market value of a firm is determined by its real assets and the cash flows they generate. Splitting those cash flows between debt and equity does not change total value, so no capital structure is better than another. The option claiming value rises with debt describes the with-tax case, not the no-tax case.

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