Use MM theory to explain the effect of capital structure on the equity cost of capital...

Use MM theory to explain the effect of capital structure on the equity cost of capital and WACC a) in perfect markets; and b) when corporate tax exists. (No calculation is needed.)

Expert Solution

According To Modigliani Miller approach , The Cost of Capital is independent of its capital structure , The market value of a firm is unaffected is unaffected by the fact that whether a firm is higky levered or has a lower debt component rather the market value of a firm is solely dependent on the operating profits of the company .

Modigliani Miller approach works well in a perfect market

But in the real world capital market , imperfection arises in the capital structure of a firm which affect the valuation

Now we will examine the effect of corporate taxes in the capital structure of a firm along with MM hypothesis . Debt financing is beneficial because interest paid is tax deductible whereas retained earnings or dividend is not tax deductible . So a firm with debts will be higher than the firm with no debts .

jeff jeffy answered 2 years ago

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