Question

Which of the following statements is FALSE?

A. Franco Modigliani and Merton Miller argued that with perfect capital markets, the total value of a firm should not depend on its capital structure.

B. Because the cash flows of the debt and equity sum to the cash flows of the project, by the Law of One Price the combined values of debt and equity must be equal to the cash flows of the project.

C. Leverage decreases the risk of the equity of a firm.

D. It is inappropriate to discount the cash flows of levered equity at the same discount rate that we use for unlevered equity.

Answer 1

Statement C is False

Leverage increases the risk of the firm. HIgher the leverage, higher the debt burden and higher is the chance that the firm can default. This reduces its creditworthiness and also its risk to equity shareholders.

A is True. In perfect capital markets the capital structure of a company is not a factor in its value since there are no taxes.

B is true: If the cash flows of debt and equity separately equate to the cash flows of the project, the sum of cash flows of debt and equity will also equate to the cash flows of the project.

D is true: The discount rates for levered and unlevered equity differ due to difference in risk in both cases.