Question

Which of the following statement is true regarding the Modigliani and Miller (M&M) propositions (1958) in a perfect financial market?

A) Capital structure is irrelevant because of the assumption that investors and companies have differing tax rates.

B) It is assumed that the firm’s future cash flows remain fixed under any circumstances.

C) The basic lesson of M&M propositions is that company’s capital budgeting decisions are dependent upon the company's capital structure decision.

D) The debt-to-equity ratio is an important measure of the firm’s operational risk.

E) The firm’s cost of capital (WACC) is not affected by leverage; however, the firm’s cost of equity RE may be affected by leverage.

Answer 1

E) The firm’s cost of capital (WACC) is not affected by leverage; however, the firm’s cost of equity RE may be affected by leverage.

Because according to MM's Hypothesis as we increase the debt in the capital structure the cost of equity is going to increase because of the higher possibility of default. as we increase the debt which is cheaper source of finance the cost of capital should decrease but because of increase in the cost of equity overall cost of capital will remain the same and the cost equity as i mentioned above will increase.

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