Impact of Capital Structure on Firm Value

Hard Capital Structure Decisions Modigliani-miller Propositions

Consider a firm that is contemplating a change in its capital structure by increasing its debt level significantly. It currently operates in a frictionless market with no taxes, bankruptcy costs, or agency costs. The firm believes that leveraging its capital structure will enhance its value in the eyes of investors.

According to the Modigliani-Miller propositions, what would be the effect of this decision on the overall value of the firm?

The value of the firm will increase due to the tax shield provided by interest payments.

The value of the firm will remain the same as the capital structure does not affect firm value in a frictionless market.

The value of the firm will decrease due to increased risk of bankruptcy associated with higher debt levels.

Hint

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