Modigliani-Miller Proposition and Capital Structure

Very Hard Capital Structure Decisions Modigliani-miller Propositions

Consider a firm currently operating in a perfect capital market, characterized by zero taxes, asymmetries, and bankruptcy costs. According to the Modigliani-Miller (MM) Proposition II, the firm's weighted average cost of capital (WACC) is influenced by its capital structure. Assume Company XYZ has the following characteristics:

- Total assets valued at $1,000,000.

- An unlevered cost of equity of 10%.

- The firm can access debt at an interest rate of 5%.

If Company XYZ decides to leverage its capital structure by issuing debt equivalent to 100% of its total assets, calculate the effect of this decision on the firm's overall cost of equity and WACC, keeping in mind that MM Proposition II posits that the cost of equity remains consistent and rises as leverage increases.

Based on this information, which of the following statements is true regarding Company XYZ's capital structure and its implications?

The firm's WACC will decrease as it increases leverage because the cost of debt is lower than the cost of equity.

The firm's cost of equity will increase, making WACC higher than the unlevered state, but still lower than the cost of equity without debt.

The firm's WACC remains unchanged due to the MM Proposition I, asserting that capital structure is irrelevant in perfect markets.

Hint

Submitted9.0K

Correct7.9K

% Correct87%