Question

Which one of the following statements matches M&M Proposition I without taxes? The value of a...

Which one of the following statements matches M&M Proposition I without taxes?

The value of a firm is dependent on the firm's capital structure.

The cost of equity capital has a positive linear relationship with a firm's capital structure.

The dividends paid by a firm determine the firm's value.

The cost of equity capital varies in response to changes in a firm's capital structure.

The value of a firm is independent of the firm's capital structure.

Homework Answers

Answer #1

The correct answer is last option(The value of a firm is independent of the firm's capital structure).

According to M&M Proposition I without taxes, the market value of the firm doesn't change due to the proportion of the debt and equity. Proposition I concludes that the capital structure doesn't matter- a firm that has the same value whether it is unlevered or highly levered. This is based on the argument that investors do not need firms to choose debt financing investors who wish to take on more risk through debt financing can do so on their own. The market value of the firm is independent of its capital structure and is given by capitalising its expected return with firm's average cost of capital.

Changing the leverage cannot have any effect on the value of the firm. That is why the value of the firm is independent of the firm's capital structure.

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