ACCA Advanced Financial Management (AFM) Practice Exam

According to the Modigliani-Miller theorem, what is the relationship between a firm's market value and its capital structure?

1. Market value is affected by capital structure

2. Market value is independent of capital structure

3. Market value is directly proportional to capital structure

4. Market value increases with leverage

The correct answer is: Market value is independent of capital structure

The Modigliani-Miller theorem posits that, under certain ideal conditions (such as no taxes, no bankruptcy costs, and efficient markets), the capital structure of a firm does not affect its overall market value. This means that the way a firm finances its operations—whether through debt, equity, or a combination of both—does not impact the total value of the firm as perceived by the market. In practical terms, the theorem argues that investors can create their own leverage by borrowing on their own account, thus making the firm's value independent of its capital structure. As a result, financing decisions (such as the mix of debt and equity) do not change the fundamental value of the underlying assets, because investors can replicate that leverage in a frictionless market scenario. This insight is critical for financial managers and investors, as it implies that changes in the firm's leverage will not inherently increase or decrease its market value. Instead, the focus should be on operational efficiency and cash flows rather than on the capital structure. The ideal conditions outlined by the theorem may not hold true in the real world due to taxes, bankruptcy costs, and other market imperfections; however, the theorem provides a foundational understanding of the relationship between capital structure and firm value.