Question

The noted Professors of Economics, Modigliani and Miller, theorized that absent taxes or costs related to financial distress:

a) The value of a firm is independent of its capital structure.

b) The value of a firm can be manipulated by capturing arbitrage opportunities in the markets for the firm's securities.

c) The cost of equity capital increases as the percentage of debt in the capital structure increases.

Both A and C.

Both B and C.

Answer 1

Answer - Both A and C are correct

Reason - firstly As per Modigliani and Miller's theory in absence of taxes or cost related to financial distress capital structure is irrelevant to find value of firm which means the company will not be able to take tax advantage on payment of interest and debt holders and equity holders have equal right on earnings.

Secondly it according to MM's theory as the firm increases financial leverage the cost of equity increases.

Debenture holders have a preference on companies earnings over the equity holders and they have a lower expectation of return than equity shareholders. So as the proportion of debt increases, the excess earnings are reverted to equity holders holding higher risk.

Which means as the company increases percentage of debt in the company, the equity cost of capital increases.

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