What does the MM theory with no taxes state about the value of a levered firm versus the value of an otherwise identical but unlevered firm? What does this imply about the optimal capital structure?
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What does the MM theory with no taxes state about the value of a levered firm versus the value of an otherwise identical but unlevered firm? What does this imply about the optimal capital structure? |
Explanation
The MM theory states that:
Value of a levered firm- Capital structure is partially financed with debt and partially by equity. Therefore dividends are paid to the shareholders after subtracting interest on debt, which are to be paid to debt holders, from EBIT.
Value of an unlevered firm- It does not have growth plans and pays no tax therefore whole EBIT can be paid in form of dividends to the debt holders. This means EBIT is equal to the cash flows.
The benefit attached to the cheaper debt issue will be offset by a higher risk involved with it; therefore, the firm's value is unaffected by its capital structure.
Verified Answer
The value of a levered firm is when the firm has both levered firm's stock and debt whereas the value of an unlevered firm is when the firm has no growth therefore pays dividends to their stockholders.
The MM theory assumes that the firm's value is not affected by its capital structure.
