MM Proposition II with taxes:
A)explains how a firm's WACC increases with the use of financial leverage.
B)reveals how utilizing the tax shield on debt causes an increase in the value of a firm.
C)supports the argument that business risk is determined by the capital structure employed by a firm.
D)supports the argument that the cost of equity decreases as the debt-equity ratio increases.
E)reaches the final conclusion that the capital structure decision is irrelevant to the value of a firm.

Question

Quizplus · Accepted Answer

MM Proposition II with taxes states that the value of a firm increases with the use of financial leverage due to the tax shield provided by debt. This is because interest payments on debt are tax-deductible, reducing the taxable income of the firm and therefore lowering the amount of tax paid. This leads to an increase in the after-tax cash flows available to equity holders, increasing the value of the firm. Therefore, choice B is the correct option.

MM Proposition II with Taxes