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2. Firm value and capital structure in the absence of tax. Assume a zero corporate tax...

2. Firm value and capital structure in the absence of tax. Assume a zero corporate tax rate. Because both the risk of a firm’s equity and debt increase with debt financing, then the value of the firm should decrease when it uses more and more debt. True or false?

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Answer #1

Answer-

The statement is False.

As per the MM Proposition I (No taxes) the capital structure irreelevance proposition when there are no taxes the value of the firm is unaffected by its capital structure.

The proposition of debt and equity does no effect the value of firm in the world of no taxes. The value of the firm remains same but will not decrease with increase in the debt with no taxes. The debt financing is irrrelevant and will not effect the value of firm.

The value of the firm without leverage (Unlevered ) (VU) is equal to the value of the firm with leverage (VL).

VL = VU

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