Modigliani and Miller\'s Irrelevance Hypothesis regarding corporate capital stru
ID: 2763488 • Letter: M
Question
Modigliani and Miller's Irrelevance Hypothesis regarding corporate capital structure assumed: (1) no taxes (2) no costs of financial distress (3) investors can borrow and lend at the same rates as firms (4) no transactions costs, Under these assumptions, which of the following is true? A. As more debt is added to the firm's capital structure: firm value increase. WACC decreases, the required rate of return on equity increases. B. As more debt is added to the firm's capital structure: firm value does not vary, WACC does not vary, the required rate of return on equity increases. C. As more debt is added to the firm's capital structure: firm value does not vary, WACC does not vary, the required rate of return on equity does not vary. D. As more debt is added to the firm's capital structure, firm value increases, WACC increases, the required rate of return on equity increases.Explanation / Answer
Correct Answer is B.
As per MM Approach, if there is no taxes, the value of levered firm (with debt) = Value of Un-levered firm (no debt).
There is neither advantage nor disadvantage in using debt in the firm’s capital structure.
Hence, Firm value and WACC does not vary.
An increase in the use of debt which is cheaper is offset by an increase in the equity capitalization rate. This happens because equity investors seek higher compensation as they are opposed to greater risk due to the existence of fixed return securities (Debt) in the capital structure.
Hence these all true on the basis of MM Approach of Capital Structure:
As more debt is added to the firm's capital structure: Value of firm does not vary; WACC does not vary and the required rate of return on equity increases.
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