Question

If we acknowledge the existence of corporate taxes (while still ignoring other market imperfections such as bankruptcy), which of the following statements about capital structure is true according to M&M?

Statement I: Increasing leverage will increases the required return on equity but will not change the value of the firm.

Statement II: Increasing leverage will increase the value of the firm.

Statement III: Increasing leverage will increase the present value of the tax shield.

Answer 1

There were 2 propositions in M & M

According to 1st proposition company capital structure does not impact the value of the firm, means it is irrelevant to the value of the firm.

2nd proposition is company's cost of equity is directly proportional to the company's leverage level. Increase in leverage will increases the required retrurn on equity

so conclusion is Increase in leerage will increases te required return on equity but will not change the value of the firm

Statement 1 is correct