CFA Level I · CFA Level I Exam · Capital Structure
Under Modigliani-Miller Proposition II with corporate taxes, compared with the no-tax case, a levered firm's weighted average cost of capital as debt increases most likely:
WACC declines as debt increases. Interest is tax deductible, so the after-tax cost of debt is lower and the tax shield adds value; the higher cost of equity only partly offsets it. Constant WACC holds only in the no-tax case.
- ADeclines because interest is tax deductibleCorrect
- BRises because the cost of equity increases
- CRemains constant because of offsetting cost changes
Explanation
With taxes, the after-tax cost of debt is rd(1−t), and the rise in the cost of equity is not enough to offset the tax shield. WACC therefore falls as leverage rises, and value is maximized at 100% debt in the theory. The constant-WACC result applies only without taxes.
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