Question

Which of the following statements are correct about Modigliani and Miller’s propositions with taxes?

A. A firm's weighted average cost of capital stays constant as the firm’s debt-equity ratio increases.

B. The value of an unlevered firm is equal to the value of a levered firm plus the value of the interest tax shield.

C. The capital structure of a firm does not matter for firm value because investors can create homemade leverage.

D. The value of a firm increases as the firm's debt increases because of the interest tax shield.

E. Modigliani and Miller’s propositions with taxes and without taxes both imply that the firm’s cost of equity should be increasing in the debt-equity ratio.

F. The firm’s weighted average cost of capital is equal to r_U×(1-T_c) where r_U is the firm’s unlevered cost of capital and T_c is the firm’s corporate tax rate.

Group of answer choices

A and C only

B and D only

D and E only

D, E, and F only

Answer 1

The correct answer is: D and E only

A. A firm's weighted average cost of capital stays constant as the firm’s debt-equity ratio increases. This is not correct. In the presence of taxes, the WACC decreases as D/E increases, reaches a minimum and then again starts increasing.

B. The value of an unlevered firm is equal to the value of a levered firm plus the value of the interest tax shield. Not correct, this is other way round. The value of an levered firm is equal to the value of a unlevered firm plus the value of the interest tax shield.

C. The capital structure of a firm does not matter for firm value because investors can create homemade leverage. This is correct, in the absence of taxes. In the presence of taxes, this is not correct.

D. The value of a firm increases as the firm's debt increases because of the interest tax shield. This is correct.

E. Modigliani and Miller’s propositions with taxes and without taxes both imply that the firm’s cost of equity should be increasing in the debt-equity ratio. This is correct.

F. The firm’s weighted average cost of capital is equal to r_U×(1-T_c) where r_U is the firm’s unlevered cost of capital and T_c is the firm’s corporate tax rate. This is not correct, The impact of tax is only on the cost of capital driven by the debt portion.