Asked by Elizabeth Inyang on Jul 13, 2024
Verified
In the MM model, the risk of bankruptcy:
A) reduces the present value of the tax shield of debt.
B) reduces the positive effect of financial leverage on firm value.
C) eliminates the possibility of a net positive effect of financial leverage on firm value.
D) has no impact on the relationship between financial leverage and firm value.
E) a and b
MM Model
The Modigliani-Miller theorem, proposing that in a perfect market, the value of a firm is unaffected by how it is financed, whether through debt or equity.
Financial Leverage
The use of borrowed funds with a fixed cost to enhance the potential return on investment.
Bankruptcy Risk
The risk that a company will be unable to meet its financial obligations and thus may have to declare bankruptcy.
- Acknowledge the significance of the Modigliani and Miller (MM) model on the theories of capital structure.
Verified Answer
SH
Shubham HandaJul 19, 2024
Final Answer :
B
Explanation :
According to the MM model, financial leverage can have a positive effect on firm value by reducing taxes paid and increasing earnings available to shareholders. However, as the risk of bankruptcy increases, the cost of debt also increases, offsetting the benefits of financial leverage. Therefore, the positive effect on firm value is reduced or eliminated as bankruptcy risk increases.
Learning Objectives
- Acknowledge the significance of the Modigliani and Miller (MM) model on the theories of capital structure.