Economics · Capital Structure Theories
Which of the following statements about capital structure and company valuation under Modigliani and Miller's (M&M) theory is correct?
Verified Solution4 OptionsUpdated: October 2026👁️1 View
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- 1The value of an ungeared company is always greater than the value of a geared company with the same operating profit under M&M's theory without tax.
- 2Under M&M's theory with tax, the optimal capital structure is to use as much debt as possible to maximize the tax shield.✓
- 3Under M&M's theory with tax, the WACC increases with increasing gearing due to the higher financial risk to equity holders.
- 4Under M&M's theory without tax, the WACC decreases with increasing gearing due to the cheaper cost of debt.
Correct answer
Under M&M's theory with tax, the optimal capital structure is to use as much debt as possible to maximize the tax shield.
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