Question

Which of the following statements concerning capital structure theory is NOT CORRECT?

		The major contribution of Miller's theory is that it demonstrates that personal taxes decrease the value of using corporate debt.
		Under MM with zero taxes, financial leverage has no effect on a firm's value.
		Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt.
		Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing.
		Under MM with corporate taxes, the effect of business risk is automatically incorporated because rsL is a function of rsU.

Answer 1

The correct option: Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing.

Explanation: r_sL = r_sU + ( r_sU - r_d) ( 1 - T ) ( D / S )

Therefore, r_s moves in the same way as leverage. When leverage increases, r_s also increases, and this increase is enough to offset the lower cost debt, and increased use of cheaper debt reduces the firm's overall cost of capital resulting in optimal capital structure.