Question

1. According to the Modigliani Miller approach, how does using debt affect the business value?

Answer 1

Answer

The Modigliani – Miller is identical with the Net Operating Income Approach. Modigliani and
Miller argued that, in the absence of taxes the cost of capital and the value of the firm are not affected
by the changes in capital structure. In other words, capital structure decisions are irrelevant and value
of the firm is independent of debt – equity mix.

Explanation of how using the debt affect the business

Many business organization like to operate the business as debt free But a reasonable amount of debt can provide some financial benefits.Debt is cheaper than equity and the debt's interest payments are tax deductable.So, as the level of debt increases, returns to equity owners also increase enhancing the company’s value.

If debt risk is not a factor then the more debt a business has, the greater its value would be. But at a certain level of debt, the risks associated with higher leverage begin to outweigh the financial advantages.When debt reaches this point, investors may expect higher returns as compensation for taking on greater risk, which has a negative impact on business value.