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CA Intermediate · Financial Management and Strategic Management · Financing Decisions - Capital Structure

Under the Modigliani-Miller (MM) proposition without taxes, which statement about a firm's cost of equity as it increases debt in its capital structure is correct?

Under MM without taxes, the cost of equity rises linearly with the debt-equity ratio. The rise exactly offsets the benefit of cheaper debt, so the overall cost of capital and firm value stay unchanged whatever the capital structure.

  1. AThe cost of equity rises linearly with the debt-equity ratio, keeping the overall cost of capital constantCorrect
  2. BThe cost of equity falls because debt is cheaper than equity
  3. CThe cost of equity stays constant because debt is cheaper
  4. DThe cost of equity falls and overall cost of capital also falls

Explanation

MM (no taxes) says WACC and firm value are independent of capital structure. Cheaper debt is exactly offset by a higher cost of equity, which rises linearly with D/E: Ke = Ko + (Ko - Kd) x D/E. Hence the cost of equity does not fall or stay constant.

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