Implications of Capital Structure According to Modigliani-Miller

Hard Capital Structure Decisions Modigliani-miller Propositions

Consider a firm, XYZ Corp., which is currently fully equity-funded with no debt in its capital structure. The firm has stable cash flows, low business risk, and operates in a competitive market. Recently, the management is contemplating increasing its leverage by issuing debt to repurchase shares, adhering to the Modigliani-Miller Proposition II with taxes. Among the following statements regarding the implications of this planned capital structure restructuring, which one correctly aligns with Modigliani-Miller's theorem?

Increasing debt will lower the overall cost of capital, as interest expense is tax-deductible.

The company's value will remain unchanged irrespective of the debt level since the market is efficient.

The equity holders will see an increase in the expected return as debt increases, even without the tax shield.

Hint

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