6. Modigliani and Miller assumptions

In 1958 Franco Modigliani and Merton Miller (MM) published a set of research papers that revolutionized the theory of a corporation's capital structure. In their first research paper, MM proposed a set of assumptions that, on the surface, may seem unrealistic, but these assumptions and MM's algebraic approach provided the first significant attempt to study capital structure theory in a scientific fashion. The original assumptions that were used in MM's first study were changed by MM and other researchers as the theory of capital structure evolved.

Which of the following statements are assumptions that Modigliani and Miller used in their initial (MM Proposition I) model and research paper? Check all that apply.

There are no taxeseither personal or corporate.

Investors have different expectations about firms' earnings and risk.

There are no costs associated with a bankruptcy.

The cost of debt increases with the level of debt.

All investors are rational, and have the same expectations of a company's earnings (as measured by its EBIT).

Stocks and bonds are traded in perfect markets, such that there are no transaction (or brokerage) costs and all corporate and individual investors can borrow and lend at the same rate of interest.

Consider the following statement about a firm's capital structure:

The firm's weighted average cost of capital (WACC) is unaffected by its capital structure.

Is the preceding statement consistent with the conclusions of Modigliani and Miller's 1958 capital structure theory (MM Proposition I)?

Yes

No