Understanding Modigliani-Miller Propositions with Taxes

Medium Capital Structure Decisions Modigliani-miller Propositions

XYZ Corporation is evaluating its capital structure and the potential implications of leveraging versus maintaining an all-equity structure. The CFO references the Modigliani-Miller propositions, which assert that, under certain conditions, the value of a firm is not affected by its capital structure. However, the firm operates in a world that includes taxes. The CFO wants to understand the impact of leverage on firm value in the presence of corporate taxes.

Which of the statements below regarding the Modigliani-Miller propositions and corporate taxes is correct?

In a world with corporate taxes, the value of a leveraged firm is equal to the value of an unleveraged firm plus the present value of the tax shield on debt.

Modigliani-Miller propositions suggest that capital structure does not affect a firm's cost of equity.

According to the propositions, increasing leverage will always lead to an increase in the weighted average cost of capital (WACC).

Hint

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