When the assumptions of Modigliani and Miller’s Irrelevance Hypothesis regarding
ID: 2802057 • Letter: W
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 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.
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.
Firm value and WACC are independent of the firm's capital structure.
Each firm has an optimal capital structure where firm value is minimized.
Each firm has an optimal capital structure where WACC is maximized.
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.
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.
Firm value and WACC are independent of the firm's capital structure.
Each firm has an optimal capital structure where firm value is minimized.
Each firm has an optimal capital structure where WACC is maximized.
Explanation / Answer
Modigliani and Miller theory assumes that firm value is independent of capital structure.
This is made based on perfect market.
But there are imperfections due to taxes, cost of financial distress.
Debt initially add value to the firm due to interest deductibility.
If we add debt to a firm having 100% equity by retiring some amount of equity:
Value of Levered firm(Firm having debt in capital structure)=Value of un levered firm+ Present value of debt Tax shield (interest expenses are deducted from Income , hence tax is reduced)
Weighted Average Cost of Capital also reduces because after tax cost of debt=Before tax cost*(1-Tax rate)
As leverage increases, the probability of financial distress increases. The firm may not be able to meet its high interest obligation leading to financial distress.
Hence the equation is changed to:
Value of Levered firm=Value of un levered firm+ Present value of debt Tax shield +Present value of Financial distress costs
Financial distress cost reduces firm’s value.
As debt increases, because of higher risks, the cost of debt also increases. Beta of equity also increases. Increase in beta increases required return on equity. The combined effect will be to increase WACC. Increase in WACC also decreases firms value ( by reducing the Present Value of the future cash flows)
Hence Option1 is correct:
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.
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