In the Modigliani Miller perfect world with no taxes, if we assume that the effe
ID: 2779449 • Letter: I
Question
In the Modigliani Miller perfect world with no taxes, if we assume that the effect of adding debt to firm's capital structure is exactly balanced by an increase in the cost of equity as more debt is added, what is the effect of increased debt usage on the weighted average cost of capital (WACC)?
WACC increases continuously as leverage increases.
WACC decreases continually as leverage increases.
WACC remains constant as leverage increases.
WACC first increases, then decreases as leverage increases.
Explanation / Answer
In the business environment of no-taxes, capital structure is irrelevant in determining the WACC (Weighted Average Cost of Capital) as per MM proposition I and II with no-taxes. The cost of equity of the firm increases with the increase of debt in capital structure only to offset the increased level of risk on firm’s equity. Thus, the WACC remained constant for any level of debt.
Therefore, the correct answer is option c.