Question

In a world with corporate taxes, MM theory implies that all firms should:

a. maintain a constant value.
b. decrease in value as the leverage of the firm increases.
c. choose an all-debt capital structure.
d. select the capital structure that maximizes the firm's WACC.
e. select the capital structure that equates the marginal cost of debt with the marginal benefits.

Answer 1

C. Choose an all-debt capital structure.

Step-by-step explanation:

The MM theory, which is known as Modigliani–Miller theory and often referred to as capital structure irrelevance principle, stated that, in a world without taxes, the cost of bankruptcy, agency, and asymmetric information, is unaffected, and also, the value of a firm in an efficient market, is unaffected by how that firm is run.

In other words,the theory stated that in the absence of taxes for a firm, it is irrelevant whether a company finances its growth by means of borrowing, by issuing stock shares, or by reinvesting its profits

However, since the real world includes corporate taxes, then the interest on debt is tax-deductible, and without considering other factors, the value of the company increases in proportion to the amount of debt used.

Hence, in the real world case, the theory stated that all company or firm should choose an all - debt capital structure.

Answer 2

Answer: c. Choose an all-debt capital structure.

Step-by-step explanation:

The Modigliani–Miller (MM) theorem is a very important element of Economic theory with it's basis on Capital Structure.

For the purpose of this question one of those arguements is that a firm should choose an all debt structure in a world with Corporate taxes.

Why?

As you may or may not know, interest is tax deductible. That means that a firm that has debt has a lower tax burden than a firm that does not.

It is wise therefore to have All debt structuring because the cost of borrowing is minimized.