Question

4. Which of the following is CORRECT about M&M theory on capital structure?

A) In a perfect MM world, capital structure does not matter for equity risk.

B) In a perfect MM world, higher leverage leads to a higher firm value.

C) In a MM world with only corporate tax, capital structure does not matter for equity risk.

D) In a MM world with only corporate tax, higher leverage leads to a higher firm value.

Answer 1

In a perfect world, MM theory states that capital structure does not matter for the value of the firm. In a perfect MM world, higher leverage does not lead to a higher firm value.

In a MM world, where there exists corporate taxes, the capital structure matters and an increasing leverage leads to an increase in the value of the firm.

So, the correct option is option D.