Question

The basic point being made by Modigliani and Miller is that in the absence of taxes and transaction costs

1. the optimal capital structure balances the firm’s tax-shield and financial distress costs.

2. a firm cannot change the total value of its outstanding securities by changing its capital structure

3. greater debt leads to a lower weighted-average cost of capital and greater firm value.

4. we must account for the timing and risk of cash flows in order to properly value the firm.

5. when new projects are added to the firm, the firm’s value is the sum of its old value plus the value of the new project.

Answer 1

Modigilani and Millar theory states that the value of the firm in absence of taxes and transaction cost reamins the same irrespective of whether the firm is levered (mix of debt and equity) or unlevered(only equity).

That means value of the firm is not depending on the choice of financial decision or capital structure of the firm.

Therfore, Option 2 is the correct answer which states that a firm cannot change the total value of its outstanding securities by changing its capital structure.