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 weighted average cost of capital indefinitely.
B) Increased usage of financial leverage will lower a firm's weighted average cost of capital indefinitely.
C) Increased usage of financial leverage will not affect a firm's weighted average cost of capital.
D) Increased usage of operating leverage will increase a firm's weighted average cost of capital indefinitely.

Question

Quizplus · Accepted Answer

The introduction of taxes means that interest payments on debt can be tax-deductible, making debt financing cheaper than equity financing. Therefore, as the usage of financial leverage increases, the cost of capital should decrease. However, bankruptcy costs are not included in this scenario, so there is no limit to how much debt a firm can take on before its cost of capital increases again.

Which of the Following Will Happen If the Original Modigliani