Which of the following statements best reflects the key insight of the M&M Proposition (without taxes)?

Question

BlackTom AI · Accepted Answer

The question asks for the statement that best captures the key insight of the Modigliani–Miller Proposition without taxes.
Option 1: 'The cost of equity remains constant regardless of the firm's debt level.' This is not aligned with MM Prop I. In the no-tax world, the cost of equity increases as leverage rises to offset the tax-advantaged use of debt in the capital structure; thus equity returns adjust to keep overall firm value unaffected. So this statement is incorrect.
Option 2: 'The value of a firm is maximized by minimizing its cost of debt.' While debt cost matters for a firm, MM Prop I in a no-tax world asserts that total firm value is independent of capital structure, meaning simply minimizing debt cost does not by itself maximize value. This misstates the core idea and conflates cost of debt with overall value. Therefore this option is incorrect.
Option 3: 'The value of a firm does not depend on how it is financed.' This matches the central insight of MM Prop I without taxes: in a perfect capital market with no taxes, the firm’s market value is determined by its underlying assets and is unaffected by whether financed with debt or equity. The mix of financing does not change value, as any advantage from debt is offset by increased cost of equity, keeping value steady. This option is correct.
Option 4: 'A firm can increase its overall value by increasing its use of debt in the capital structure.' This statement describes the levered value proposition that arises when tax shields exist (in productions with taxes), but under MM Prop I without taxes there is no tax advantage to debt, so increasing debt does not raise value. Hence this option is incorrect in the no-tax context.
Option 5: 'A firm's equity value is inversely related to its debt-equity ratio.' While leverage changes the distribution of value between debt and equity, in the MM world without taxes the total firm value stays the same as leverage changes, so equity value alone is not simply inversely tied to debt-equity ratio. This statement misstates the core proposition and is therefore incorrect.
In summary, the statements eliminate options that misstate the effect of capital structure on firm value, and among them, the one asserting that firm value does not depend on financing choice captures the essential MM Prop I insight in a no-tax framework.

FA25-BL-BUS-F305-1130 Final Exam

Which of the following statements best reflects the key insight of the M&M Proposition (without taxes)?

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In a world with perfect capital markets, a firm that issues a large amount debt to finance a share repurchase will ultimately boost its EPS and reduce its post-transaction market capitalization, but will not affect its stock price.

In a world with corporate taxes (only capital markets imperfection), a levered firm will issue equity to repay some of its debt. Indicate which of the following statements is correct:

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