ACCA Advanced Financial Management (AFM) Practice Exam

What is the overall implication of the Modigliani-Miller theorem on firm valuation?

1. Higher levels of debt always increase firm value

2. Capital structure choices do not affect overall firm valuation

3. Equity financing is always preferable

4. Leveraged firms are risk-free

The correct answer is: Capital structure choices do not affect overall firm valuation

The Modigliani-Miller theorem posits that under certain assumptions, particularly in a world with no taxes, no bankruptcy costs, and efficient capital markets, the capital structure of a firm does not influence its overall value. This principle suggests that a company's value is determined solely by its underlying assets and business operations, rather than how it is financed—be it through equity or debt. This means that, according to the theorem, variations in the levels of debt within a firm's capital structure should not have an impact on the overall market value of the firm. Consequently, regardless of whether a firm opts for equity financing, debt financing, or a combination of both, these choices do not inherently alter the firm's valuation. Thus, the essence of the Modigliani-Miller theorem supports the idea that capital structure is irrelevant to firm valuation under its assumptions, aligning perfectly with the option indicating that capital structure choices do not affect overall firm valuation. The other choices focus on aspects that are not aligned with the core principles of the theorem, such as suggesting that higher levels of debt always increase firm value or that equity financing is universally preferable, both of which imply a relationship between financial leverage and value that the theorem disputes. Similarly, the notion that leveraged firms are risk