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The lesson contrasts the traditional theory of capital structure with the alternative theory of Modigliani and Miller. What is the central proposition of the Modigliani and Miller (MM) theory as stated in the lesson?
Answer & Solution
Correct answer: C.
1. The lesson contrasts traditional and MM theories on capital structure.
2. The MM theory argues that the cost of capital is independent of the capital structure.
3. The essence of the argument is the arbitrage process between firms with identical incomes and risk classes.
4. Investors can arbitrage between companies and between loan and equity capital to equalise market values.
5. The other statements misstate the MM proposition.
_Source: ICSI CS Executive Paper 8 (Financial and Strategic Management) — Lesson 1: Nature, Significance and Scope of Financial Management, pp. 6-20._
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