Question

The main difference between MM II (Modigliani Miller Model with Corporate Taxes) and Miller Model with Corporate and Personal Taxes is:

		MM II concludes that a capital structure with 100% debt is optimal but the Miller Model states that a capital structure with 100% equity is optimal.
		MM II concludes that a capital structure with 100% equity is optimal but the Miller Model states that a capital structure with 100% debt is optimal.
		Both conclude that a levered firm's value will be lower than an unlevered firm's but the size of that disadvantage is bigger in MM II's model.
		Both conclude that a levered firm's value will be higher than an unlevered firm's but the size of that advantage is unknown in MM II's model.
		They both conclude that debt increases value of the firm under the current tax code but the size of the advantage is different in the two models.

Answer 1

The theories state that valuation of firm and capital structure are unrelated.

The cost of equity increases with leverage, and this increase exactly offsets the advantage of using lower cost debt financing.

The Miller model introduces personal taxes. The effect of personal taxes is, essentially, to reduce the advantage of corporate debt financing.

Option 1 & 2 are both incorrect, as capital structure is irrelevant as per these models. These models do not recommend any optimal mix of debt and equity. (The theories state that valuation of firm and capital structure are unrelated)

Option 3 & 4 are both incorrect, as the value of levered firm and unlevered firm are equal under these 2 models. (The cost of equity increases with leverage, and this increase exactly offsets the advantage of using lower cost debt financing)

Hence the correct option is - They both conclude that debt increases value of the firm under the current tax code but the size of the advantage is different in the two models. (The Miller model introduces personal taxes. The effect of personal taxes is, essentially, to reduce the advantage of corporate debt financing.)