The correct answer is: C. Both 1st and 3rd statements.
The MM proposition I states that in a perfect market, the value of a firm is independent of its capital structure. This means that the firm’s value is not affected by the amount of debt or equity it uses to finance its assets.
The MM proposition II states that in a perfect market, the cost of capital is also independent of the firm’s capital structure. This means that the firm’s cost of capital is the same regardless of the amount of debt or equity it uses to finance its assets.
However, these propositions are based on a number of assumptions, including the following:
- There are no taxes.
- There are no agency costs.
- There are no information asymmetries between managers and shareholders.
- There are no bankruptcy costs.
If any of these assumptions are violated, then the MM propositions may not hold.
For example, if there are taxes, then firms can use debt financing to reduce their tax liability. This means that the value of a firm with debt financing will be greater than the value of a firm with no debt financing.
Similarly, if there are agency costs, then firms with more debt financing will have higher agency costs. This is because debt financing gives managers more power, which they may use to benefit themselves at the expense of shareholders.
Therefore, both the first and third statements are false. The first statement is false because if there are agency costs, then the expected agency costs increases as the debt-equity ratio decreases. The third statement is false because in the presence of taxes, the market value of the firm increases by the tax shield of debt.