Question

Modigliani and Miller Propositions: True or False and explain your answer; 1. MM's propositions assume perfect financial markets, with no distorting taxes or other imperfections. 2. MM's proposition 2 assumes that increased borrowing does not affect the interest rate on the firm's debt. 3. Borrowing does not increase financial risk and the cost of equity if there is no risk of bankruptcy. 4. Borrowing increases firm value if there is a clientele of investors with a reason to prefer debt.

Answer 1

True. MM Propositions assumes perfect financial markets with no distorting taxes or other imperfection. These are few assumptions over which MM theory is based and two of them are there are no taxes and there is symmetry of information, meaning everyone will have same access to the information. False. It is not correct that as increased borrowing does not affect the interest rates on firm's debt. It says that as debt in the capital structure increases the cost of borrowing will increase and so will the financial distress cost. The cost of equity also increases as the debt level increases. • False. Borrowing does increase the financial risk and the cost of equity. Leverage in the capital structure magnifies the return on equity. So, if there are profits then the profits will be magnified and if there are losses then they will also be magnified. False. MM theory says that the borrowing does not affect the value of the firm, however it says that the corporate borrowing increases earning per share as long as the rate of return is greater than the interest paid.