Question

Assume there are no taxes or risk of bankruptcy. The assets and operations of two firms are the same. Firm 1 is all equity financed, while firm 2 uses debt and equity.

a) The firm using debt and equity is more valuable.
b) The all-equity firm is more valuable.
c) Value depends on cash flows, which we don't know.
d) The value of both firms is the same.

Answer 1

According to the Modigliani-Miller Theorem, the value of two identical firms with different financing methods (one with all equity and the other with debt and equity) is the same when there are no taxes or risk of bankruptcy.

Step-by-step explanation:

When considering the value of two firms with identical assets and operations, where one is all equity financed (Firm 1) and the other is financed through a combination of debt and equity (Firm 2), and assuming there are no taxes or risk of bankruptcy, the Modigliani-Miller Theorem (M&M Proposition I) states that the value of both firms is the same. This theorem holds in a world without taxes, transaction costs, or bankruptcy costs, and where individuals and corporations borrow at the same rates. Despite the differences in financing, the overall value is unaffected by the capital structure of the firms. Therefore, the correct answer is d) The value of both firms is the same.