Question

Which of the following statements accurately describes the outcome of assuming that markets are perfectly competitive, that there are no taxes, that companies and individuals can borrow at the same interest rate, that there are no costs associated with liquidation or financial difficulty, and that companies' investment policies are not affected by their financing decisions?

	a.	As the level of leverage increases - the company's cost of capital is not affected as any advantage associated with switching from relatively expensive equity to cheaper debt is offset by the increased required return of the remaining shareholders
	b.	The market value of the company's assets decreases as the level of debt increases
	c.	The aggregate market value of the company's assets is affected by the company's choice of debt or equity as a source of finance
	d.	More than one of the above statements are correct
	e.	None of the above statements is correct

Answer 1

Answer-

The correct Option is a.

This is the Capital structure irrelevance proposition. ( MM I Proposition )

As the level of leverage increases - the company's cost of capital is not affected as any advantage associated with switching from relatively expensive equity to cheaper debt is offset by the increased required return of the remaining shareholders.
The increase in proportion of debt needs to be compensated to the equity holders and the cost of equity increases but the overall cost of capital or WACC remains same.

The other options b , c , d and e are incorrect.

The market value of the company's assets does not decreases as the level of debt increases. as assets = liablities + equity.

The aggregate market value of the company's assets is not affected by the company's choice of debt or equity as a source of finance and the value of unleveraged company is equal to the leveraged company.
V(L) = V(U)