Question

Which of the following statements is FALSE?

A. We can use Modigliani and Miller's first proposition to derive an explicit relationship between leverage and the equity cost of capital.
B. The total market value of the firm's securities is equal to the market value of its assets, whether the firm is unlevered or levered.
C. Although debt does not have a lower cost of capital than equity, we can consider this cost in isolation.
D. While debt itself may be cheap, it increases the risk and therefore the cost of capital of the firm's equity.

Answer 1

Answer:

A. We can use Modigliani and Miller's first proposition to derive an explicit relationship between leverage and the equity cost of capital.

Explanation:

Their main conclusions can be summarized as: In the absence of taxes, firm capital structure is irrelevant. With taxes, a firm's cost of capital can be lowered through issuing debt. This highlights the importance of debt as a tax shield.

Modigliani and Miller's conclusion went against the common view that even with perfect capital markets, leverage would affect a firm's value.