The correct answer is D. Total value does not change because underlying does not change with financing mix.
The Modigliani-Miller (MM) theorem states that in a perfect market, the value of a firm is not affected by its capital structure. This is because the firm’s capital structure does not affect its underlying cash flows, and therefore does not affect its risk. In a perfect market, investors can borrow and lend at the same rate as the firm, so they can replicate the firm’s capital structure by borrowing and lending on their own. This means that the firm’s capital structure does not affect the risk of its equity, and therefore does not affect its cost of equity. As a result, the firm’s value is not affected by its capital structure.
However, the MM theorem assumes that there are no taxes, no bankruptcy costs, and no asymmetric information. In the real world, these assumptions do not hold, and the MM theorem does not apply. For example, in the real world, firms with debt have a tax advantage because they can deduct interest payments from their taxable income. This tax advantage makes debt financing more valuable than equity financing, and therefore affects the firm’s capital structure.
In addition, bankruptcy costs can also affect the firm’s capital structure. When a firm goes bankrupt, it can incur significant costs, such as legal fees and the costs of selling assets. These costs can make debt financing more expensive than equity financing, and therefore affect the firm’s capital structure.
Finally, asymmetric information can also affect the firm’s capital structure. When investors have less information about a firm than the firm’s managers, they may be less willing to invest in the firm. This can make equity financing more expensive than debt financing, and therefore affect the firm’s capital structure.
In conclusion, the MM theorem states that in a perfect market, the value of a firm is not affected by its capital structure. However, in the real world, the MM theorem does not apply because there are taxes, bankruptcy costs, and asymmetric information. These factors can affect the firm’s capital structure and therefore its value.