In Modigliani–Miller Proposition I (no taxes, no bankruptcy costs), how does capital structure affect firm value?

• A. It does not affect firm value; capital structure is irrelevant.
• B. It increases firm value with leverage.
• C. It decreases firm value with leverage.
• D. It depends on taxes.

Answer: (C)

With no taxes and no bankruptcy costs, the value of a firm is determined entirely by the assets’ ability to generate cash flows, not by how those cash flows are financed. Modigliani–Miller Proposition I shows that changing the mix of debt and equity doesn’t create or destroy value—the total present value of the firm’s cash flows stays the same. Leverage simply redistributes who gets what portion of those cash flows and how much risk each claim bears, but it doesn’t change the overall worth of the assets.

This baseline result rests on the idea that there’s no tax shield from debt to boost value and no costs from distress to drag it down. If taxes existed, debt could raise value via the tax shield; if bankruptcy costs existed, very high leverage could lower value. In the pure, tax- and cost-free world, those channels are off, so capital structure is irrelevant to the firm’s value.