Which of the following will happen if the original Modigliani and Miller Theorem is relaxed to include taxes,but not bankruptcy costs?
A)Increased usage of financial leverage will increase a firm's composite cost of capital indefinitely.
B)Increased usage of financial leverage will lower a firm's composite cost of capital indefinitely.
C)Increased usage of financial leverage will not affect a firm's composite cost of capital.
D)Increased usage of operating leverage will increase a firm's composite cost of capital indefinitely.

Question

Quizplus · Accepted Answer

The original Modigliani and Miller Theorem states that the use of financial leverage does not affect the cost of capital. However, when taxes are introduced, the cost of debt becomes cheaper due to tax shields. This means that by increasing the use of financial leverage, a firm can lower their composite cost of capital up to a certain point. After that point, the cost of debt may increase due to higher default risk, causing the composite cost of capital to increase again. Therefore, increased usage of financial leverage will lower a firm's composite cost of capital indefinitely.

Which of the Following Will Happen If the Original Modigliani