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

Question

Quizplus · Accepted Answer

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.

In the MM Model, the Risk of Bankruptcy