M&M Proposition I with taxes states that the:
A) Debt-equity ratio does not affect the total value of a ﬁrm.
B) Cost of equity ﬁnancing increases as the debt-equity ratio rises.
C) Value of a levered ﬁrm is equal to the present value of the interest tax shield plus the value of an unlevered ﬁrm.
D) Required return on assets is determined by the level of ﬁnancial risk.
E) Return on equity is dependent upon the marginal tax rate and the debt-equity ratio.

Question

Quizplus · Accepted Answer

M&M Proposition I with taxes states that the value of a levered firm is equal to the present value of the interest tax shield plus the value of an unlevered firm. This means that the debt-equity ratio does affect the total value of a firm, contrary to M&M Proposition I without taxes. Option A is therefore incorrect. Option B is also incorrect because the cost of equity financing is not only affected by the debt-equity ratio but also by other factors such as market risk and company-specific risk. Option D is incorrect because the required return on assets is affected by both financial risk and business risk. Option E is also incorrect because the return on equity is affected not only by the debt-equity ratio and tax rate but also by other factors such as the risk-free rate and equity risk premium.

M&M Proposition I with Taxes States That The