According to the capital structure theory proposed by the Modigliani and Miller (MM), a firm's optimal capital structure is the mix of debt and equity that minimizes its weighted average cost of capital (WACC), which occurs when the firm is financed almost entirely with debt. MM argued that their conclusion is valid primarily because, in the real world, ______.
A)there are no flotation costs associated with issuing debt
B)investors pay less personal income taxes on the interest they earn on their investments in bonds than they pay on the dividends they receive from corporations
C)firms that issue large amounts of debt have much less probability of going bankrupt than firms that have little or no debt in their capital structures.
D)the amount of debt a firm uses to finance its assets does not affect its market value
E)interest paid on corporate debt is a tax-deductible expense to the firm, whereas dividends paid to stockholders are not.

Question

According to the capital structure theory proposed by the Modigliani and Miller (MM), a firm's optimal capital structure is the mix of debt and equity that minimizes its weighted average cost of capital (WACC), which occurs when the firm is financed almost entirely with debt. MM argued that their conclusion is valid primarily because, in the real world, ______. 
A)there are no flotation costs associated with issuing debt
B)investors pay less personal income taxes on the interest they earn on their investments in bonds than they pay on the dividends they receive from corporations
C)firms that issue large amounts of debt have much less probability of going bankrupt than firms that have little or no debt in their capital structures.
D)the amount of debt a firm uses to finance its assets does not affect its market value
E)interest paid on corporate debt is a tax-deductible expense to the firm, whereas dividends paid to stockholders are not.

Quizplus · Accepted Answer

MM argued that their conclusion is valid primarily because interest paid on corporate debt is a tax-deductible expense to the firm, whereas dividends paid to stockholders are not. Therefore, the more a firm uses debt in its capital structure, the greater the tax shield and the lower the WACC.

According to the Capital Structure Theory Proposed by the Modigliani