General Studies · Capital Structure Theories
Which of the following statements accurately describes the differences between the traditional theory and the Modigliani-Miller theory regarding capital structure?
- 1The traditional theory advocates for maintaining a balanced mix of debt and equity to maximize shareholders' wealth, while the Modigliani-Miller theory suggests that firms should minimize financial risk by avoiding debt altogether.
- 2The traditional theory emphasizes the importance of minimizing the weighted average cost of capital (WACC) through optimal capital structure decisions, while the Modigliani-Miller theory argues that capital structure decisions are irrelevant to WACC in a perfect capital market.✓
- 3The traditional theory asserts that the value of the firm is unaffected by changes in capital structure, while the Modigliani-Miller theory proposes that the value of the firm decreases with higher leverage.
- 4The traditional theory assumes that the cost of capital remains constant regardless of the capital structure, while the Modigliani-Miller theory suggests that the cost of capital increases with higher levels of debt.
Correct answer
The traditional theory emphasizes the importance of minimizing the weighted average cost of capital (WACC) through optimal capital structure decisions, while the Modigliani-Miller theory argues that capital structure decisions are irrelevant to WACC in a perfect capital market.
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