M&M Proposition I with taxes is based on the concept that:
A) The optimal capital structure is the one that is totally ﬁnanced with equity.
B) The capital structure of the ﬁrm does not matter because investors can use homemade leverage.
C) The ﬁrm is better off with debt based on the weighted average cost of capital.
D) The value of the ﬁrm increases as total debt increases because of the interest tax shield.
E) The cost of equity increases as the debt-equity ratio of a ﬁrm increases.

Question

Quizplus · Accepted Answer

M&M Proposition I with taxes states that the value of the firm increases as total debt increases because of the interest tax shield. This means that the optimal capital structure includes a mix of debt and equity to take advantage of the tax benefits of debt. Option A is incorrect because an all-equity financing is not optimal due to the tax benefits of debt. Option B is incorrect because homemade leverage does not eliminate the benefits of using debt in the firm's capital structure. Option C is incorrect because the value of the firm is maximized by finding the optimal mix of debt and equity, not by using only the weighted average cost of capital. Option E is incorrect because the cost of equity generally increases with financial risk, which usually increases as debt levels increase, but this is not the main concept of M&M Proposition I with taxes.

M&M Proposition I with Taxes Is Based on the Concept