A so-called theorem in corporate finance. Our two hypotheses:
- Perfect capital markets
- So firms and investors can borrow and lend at the same rate
- Equal access to all relevant information
- No transaction costs
- No taxes, but not for the second conclusion
What’s the implications of this?
- The value of the firm doesn’t depend on its capital structure
- The required rate of return on equity increases with the debt/equity ratio of the company
Recall that the weighted average cost of capital, . If equity decreases and debt increases, the should go down, but the market will ask for a higher return so the cost of equity will go up such that the will not change.