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CS Professional · Strategic Management and Corporate Finance · Sources of Corporate Funding

Under the Modigliani-Miller proposition without taxes, which statement about the value of a firm is correct?

In a perfect market with no taxes, Modigliani-Miller says firm value is independent of capital structure. Any benefit from cheaper debt is exactly offset by a rise in the cost of equity, so the overall cost of capital and total firm value remain unchanged.

  1. AFirm value rises steadily with each additional rupee of debt
  2. BFirm value is independent of its capital structure in a perfect marketCorrect
  3. CFirm value falls as debt increases because the cost of equity rises
  4. DFirm value is maximised only when debt equals equity

Explanation

MM Proposition I without taxes states that in perfect markets the value of a levered firm equals that of an unlevered firm. Cheaper debt is exactly offset by a higher cost of equity, so the weighted average cost of capital stays constant. The idea that value rises with debt applies only when corporate taxes are introduced.

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