CFA Level I · CFA Level I Exam · Capital Structure
Under Modigliani-Miller Proposition I without taxes, a firm replaces some equity with debt while its operating assets and cash flows stay the same. The value of the firm is most likely:
Firm value is unchanged. Under Proposition I without taxes, value is set by the cash flows of the operating assets and their risk, not by the mix of debt and equity. Cheaper debt is offset by a higher cost of equity.
- AUnchangedCorrect
- BHigher, because debt is cheaper than equity
- CLower, because financial risk increases
Explanation
With no taxes, no bankruptcy costs and perfect markets, firm value depends on the cash flows of the assets, not on how they are financed. Debt looks cheaper, but equity cost rises to offset it, so the weighted average cost of capital is unchanged.
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