Question

Q1) Under the M&M world with corporate taxes, the value of a firm is maximized when the firm is financed with 100% debt.

True

False

Q2) Under the M&M world with perfect capital markets, the cost of equity is independent of its capital structure.

True

False

Q3) Under the M&M world with perfect capital markets, a firm’s value should rise with increased leverage because debt is cheaper than equity.

True

False

Q4) Under the M&M world with perfect capital markets, a firm’s average cost of capital (i.e. pre-tax WACC) falls for increases in debt as long as the firm avoids truly excessive leverage.

True

False

Answer 1

Answers-

Q 1)

The statement is True.
As the debt financing provides the tax shield that adds valu to the company. The value of the company increases with increase in debt and the optimal apital structure is with 100 % debt.

Q 2)

This statement is False.
In perfect capital markets the cost of equity increases as the firm increases the proportion of debt financing. As the debt holders have priority claim over equity holders therefore the cost of equity increases with increase in debt or leverage.

Q 3)

This statement is False.
In perfect capital markets increase in debt financing does not effect the value of firm as the value of firm is unaffected with the proportion of debt and equity in capital structure. Therefore the value of fims assets will be same and be irrelevant with the proportion of debt and equity used in capital structure.  

Q 4)

This statement is False.
With perfect capital markets as the leverage (debt-to-equity ratio) or debt increases the cost of equity increases but the WACC (cost of capital) and the cost of debt remains unchanged. The WACC will not fall with increase in debt or leverage.

Important Note- Question 1 is considering taxes (with taxes) whereas the Quesions 2,3 and 4 are based on perfect capital markets which means without taxess (No taxes) under the MM proposition.