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IAI Actuarial Core Principles · Business Finance · Key principles of finance

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

Under MM proposition I with no taxes or bankruptcy costs, firm value does not depend on the debt-equity mix. Value comes from the assets' earning power and risk, and extra debt is offset by a higher cost of equity, leaving the weighted average cost of capital unchanged.

  1. AFirm value rises steadily as the proportion of debt financing increases
  2. BFirm value is independent of the mix of debt and equity used to finance its assetsCorrect
  3. CFirm value falls as debt increases because equity holders demand a higher return
  4. DFirm value is maximised when the dividend payout ratio is highest
  5. Firm value depends on the interest rate on debt rather than on the firm's assets

Explanation

With perfect markets, MM I says value is determined by the earning power and risk of the firm's assets, not by how they are financed. Increasing debt raises the cost of equity by exactly enough to offset cheaper debt, so the overall cost of capital and firm value are unchanged. The option claiming value rises with debt reflects the case with corporate taxes, not the base case.

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