When the assumptions of Modigliani and Miller’s Irrelevance Hypothesis regarding

Question

When the assumptions of Modigliani and Miller’s Irrelevance Hypothesis regarding corporate capital structure are relaxed so that they are more consistent with real-world conditions, i.e. there are corporate taxes (and interest payments are tax deductible) and there are costs of financial distress, then which of the following is true?

Firm value increases and WACC increases initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that outweigh the benefits of further reducing taxes. After this point, firm value and WACC start to decrease as more debt is added.

Each firm has an optimal capital structure where firm value is minimized.

Firm value and WACC are independent of the firm's capital structure.

Firm value increases and WACC decreases initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that outweigh the benefits of further reducing taxes. After this point, firm value starts to decrease and WACC starts to increase as more debt is added.

Each firm has an optimal capital structure where WACC is maximized.

Explanation / Answer

ANSWER

Firm value increases and WACC decreases initially as more debt is added to the firm's capital structure, however, there comes a point where adding additional debt generates potential costs of financial distress that outweigh the benefits of further reducing taxes. After this point, firm value starts to decrease and WACC starts to increase as more debt is added.

Explanation

firm value and WACC are inversally related and benifit of tax on interest is offset by potential cost of distress

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