Question

17. Which of the following statements regarding the M&M Propositions is true?

A)Without taxes, the firm's capital structure is relevant.

            B)   Without taxes, the optimal amount of leverage for a firm is zero debt.

C)   With taxes, a firm can increase its value by reducing debt.

D)   Once the tax effect is considered, there is a strictly increasing linear

       relationship between the amount of debt and the firm value.

Answer 1

Once the tax effect is considered, there is a strictly increasing linear relationship between the amount of debt and the firm value.

As the tax effect comes into the picture, the value of the firm increases with the amount of debt. Higher debt brings higher leverage benefits in the form of tax saving on interest payments thus reducing the cost of capital. As the cost decreases, the firm value increases since the value of the firm is the discounted value of future cash flows.

Without taxes the firms capital structure is irrelevant since there is no tax saving on interest. The optimal leverage of the firm is not zero debt since there is no distinction between debt and equity. With taxes, a firm can increse its value by increasing debt due to tax saving on interest payments.