Question

Which one of the following supports the theory that the value of a firm increases as the firm's level of debt increases?

A. M&M Proposition I without taxes

B. M&M Proposition II without taxes

C. M&M Proposition I with taxes

D. Static theory of capital structure

E. No theory suggests this.

Answer 1

The M&M Proposition I with taxes supports the theory that a firm's value increases with more debt due to the tax shield on interest payments. Therefore correct option is C

Step-by-step explanation:

The theory that suggests the value of a firm increases as the firm's level of debt increases is referred to as M&M Proposition I with taxes. This is part of the Modigliani-Miller theorem which includes Proposition I stating that, in a world without taxes, the value of a leveraged firm is the same as the value of an unleveraged firm.

However, when taxes are considered (which is more reflective of the real world), Proposition I with taxes suggests that the value of a firm increases with more debt because interest payments on debt are tax-deductible, which can reduce a firm's tax liability and therefore, increase its overall value. The static theory of capital structure also suggests an optimal mix of debt and equity financing to maximize a firm's value, but it differs from the M&M Propositions as it includes bankruptcy costs and agency costs.