If a firm's market value is independent of its capital structure, what effect does this have on the required return?

If a firm's market value is independent of its capital structure, what effect does this have on the required return?

• A. The required return will decrease with higher debt
• B. The required return will not be affected by the level of debt
• C. The required return will be lower for unlevered firms
• D. The required return will always increase with more debt

Answer: (B)

When a firm's market value is independent of its capital structure, this suggests that the Modigliani-Miller theorem applies in a perfect market scenario without taxes, bankruptcy costs, or other frictions. According to this theorem, the value of a firm is determined solely by its operating performance and not by how it finances its operations, whether through equity, debt, or a combination of both. As a result, if the market value remains unchanged despite variations in the level of debt the firm takes on, it indicates that investors do not require a higher return for increased leverage. The overall risk of the firm, as perceived by the market, remains constant. Therefore, the required return, which reflects the risk perceived by investors, will not be influenced by the amount of debt the firm carries. This perspective holds that leveraging a firm does not inherently increase the required return, contrary to traditional views that suggest higher leverage raises financial risk and therefore the required return on equity. The specific context of immutability in capital structure's influence on market value reinforces the idea that variations in debt level do not sway investor expectations of returns. Thus, the correct understanding is that the required return remains stable regardless of changes in the capital structure.

When a firm's market value is independent of its capital structure, this suggests that the Modigliani-Miller theorem applies in a perfect market scenario without taxes, bankruptcy costs, or other frictions. According to this theorem, the value of a firm is determined solely by its operating performance and not by how it finances its operations, whether through equity, debt, or a combination of both.

As a result, if the market value remains unchanged despite variations in the level of debt the firm takes on, it indicates that investors do not require a higher return for increased leverage. The overall risk of the firm, as perceived by the market, remains constant. Therefore, the required return, which reflects the risk perceived by investors, will not be influenced by the amount of debt the firm carries.

This perspective holds that leveraging a firm does not inherently increase the required return, contrary to traditional views that suggest higher leverage raises financial risk and therefore the required return on equity. The specific context of immutability in capital structure's influence on market value reinforces the idea that variations in debt level do not sway investor expectations of returns. Thus, the correct understanding is that the required return remains stable regardless of changes in the capital structure.