Which of the following statements is correct if we invoke the assumptions of a perfect capital market?A.The weighted average cost of capital for an unlevered firm will be exactly equal to the weighted average cost of capital of an otherwise identical levered firm.B.The weighted average cost of capital of a levered firm will exceed that of an otherwise identical unlevered firm since debt increases financial risk.C.It is impossible to draw a conclusion in the absence of further information.D.The weighted average cost of capital of an unlevered firm will be less than that of an otherwise identical levered firm since debt financing is cheaper than equity financing.
Question
Which of the following statements is correct if we invoke the assumptions of a perfect capital market?A.The weighted average cost of capital for an unlevered firm will be exactly equal to the weighted average cost of capital of an otherwise identical levered firm.B.The weighted average cost of capital of a levered firm will exceed that of an otherwise identical unlevered firm since debt increases financial risk.C.It is impossible to draw a conclusion in the absence of further information.D.The weighted average cost of capital of an unlevered firm will be less than that of an otherwise identical levered firm since debt financing is cheaper than equity financing.
Solution
The correct answer is A. "The weighted average cost of capital for an unlevered firm will be exactly equal to the weighted average cost of capital of an otherwise identical levered firm."
This statement is based on the Modigliani-Miller theorem, which states that in a perfect capital market (i.e., a market with no taxes, no bankruptcy costs, and no asymmetric information, and where investors and firms can borrow and lend at the same rate), the value of a firm is unaffected by its capital structure.
In other words, the way a firm is financed - whether through debt (a levered firm) or entirely through equity (an unlevered firm) - does not affect its overall cost of capital. This is because any increase in the cost of equity due to increased financial risk from debt is exactly offset by the tax shield benefit of debt.
Similar Questions
In a perfect capital market, the weighted-average cost of capital is defined as: . In this setting:A. is always greater than .B. only differs from because of transaction costs associated with issuing equity.C. is always equal to .D. depends upon the firm’s marginal tax rate.
Which of the following statements is FALSE?A.Franco Modigliani and Merton Miller argued that with perfect capital markets, the total value of a firm should not depend on its capital structure.B.It is inappropriate to discount the cash flows of levered equity at the same discount rate that we use for unlevered equity.C.Leverage decreases the risk of the equity of a firm.D.Because the cash flows of the debt and equity sum to the cash flows of the project, by the Law of One Price the combined values of debt and equity must be equal to the cash flows of the project.
Whenever the cost of capital for an all-equity firm is greater than the cost of debt, the cost of equity Blank______.Multiple choice question.is unaffected by leverageincreases with leveragedecreases with leverage
The weighted average cost of capital rises at higher levels of debt owing to Blank______.Multiple choice question.financial distress costshigher dividend costshigher working capitalexcess free cash flow
MM Proposition II shows that Blank______.Multiple choice question.the market value of the firm is unaffected by its capital structurethere is no risk involved with leverage when there are no corporate taxesthe cost of equity rises with leverageequity is less expensive than debt
Upgrade your grade with Knowee
Get personalized homework help. Review tough concepts in more detail, or go deeper into your topic by exploring other relevant questions.