 The relative proportion of debt, equity and other securities debt of firm issues to finance its operations or buying any of its capital investment. These securities constitute the capital structure of the firm. Now in present day, a modern corporate decides before collecting funds from its investors the type of security it thinks to issue more appropriately. It is the reason that in today's corporate world a firm can issue equity securities as a whole to finance its business or the combination of both the debt and equity securities to finance the activities of its business. So what happens when a firm finances its business to the sole issue of the equity? We have an example to understand this where we have initial investment of $800 and it is estimated that the next year's cash flow will be of two types we have two likelihoods. If the economy is strong the cash flows would be $1400 and if the economy is weak the cash flows would be $900. Now these cash flows depend upon the economy. This means that these cash flows are subject to some market risk. Now in these circumstances the market investors demand a risk premium against this market risk. Now we assume that the risk pre-interest rate is 5% and the market risk premium is 10%. So the project's overall cost of capital is equal to 15%. Now using this data we can determine the net present value of this investment project. For that purpose we have to determine the expected value of cash flows. We assume equal chances for the two likelihoods. So we have an expected value of cash flows equal to $1150. Now using these expected cash flows the NPV comes to $200 and that is positive NPV. Now there is a question that how much value should be of an equity finance project like in this particular case whereas in the absence of any arbitrage we see that the price of any security is equal to the present value of the cash flows generated by these securities. So this means that all of the cash inflows will go to the owners of this particular equity finance project. This means that present value of equity based cash flows here it is equal to the expected value of the cash flows which are $1150. If we divide these expected cash flows over the company's overall cost of capital the present value of these cash flows come to $1000. This means that for any unlevered firm its unlevered cash flows are equal to the cash flows generated by the project. Now comes to the expected return. If the economy is strong we can expect a return of 40% but in a weak economy we can expect a negative return by 10%. If we determine the expected return using these two returns the answer comes to 15%. Now we see that this expected return of 15% is equal to the overall capital of the firm which is 15%. As we have seen earlier so this can also derive us towards a conclusion that the riskiness of an unlevered equity is equal to the riskiness of the project. This means if this is the case then this means that the owners of the projects are earning an appropriate return. Now what will happen if the project is financed with both debt and equity besides financing the project solely with equity a firm can also use the combination of debt and equity but in that particular case the debt holder have prioritized claim over the cash flows of the project over the equity holders. And equity in a firm who has outstanding debt such type of equity is termed as a levered equity. Now we see an example where we have initial borrowing of 500 dollars in continuation of our earlier example and this debt is assumed to be risk free so the risk free rate of interest is 5%. Now after one year the cash flows towards the debt holders would be 525 dollars that includes the interest on debt at the rate of 5%. So if we see the cash flows we see that the levered equity holders will have the cash flows and that is a question mark whereas in strong economy these people will have a cash flow of 875 dollars and in weak economy these people will have a cash flow of 275 dollars and levered firm will have cash flow under both the cases equal to 1400 dollars and 900 dollars. Now the question arises that the levered equity and the best capital choice in this particular what will be the option for the firm whereas the MM1 says that a firm value is independent of its choice of the capital structure. This means that the firm's total cash flows should be equal to the cash flows of the project. Here comes the law of one price that says that the cash flows from debt and cash flows from the securities should be equal to the cash flows of the project. The application of law of one price says that the combined cash flows on these particular two types of securities should be equal to the cash flows generated by the project's assets and that we see that the combined cash flow is equal to 1000 dollars. This means that the levered equity has the value of 500 dollars which is the result of difference between the cash flows of the project and the cash flows related to the debt holders. So we see in this particular case that the cash flows of the levered equity are less than the cash flows of the unlevered equity because in the unlevered equity the cash flows are equal to 500 dollars whereas in this particular case the case is not. So the levered equity has low price of 500 dollars against the unlevered equity which has the value of 1000 dollars that we see in our earlier example. This means that less equity with leverage does not mean a less valuable equity because the firm can still raise a total value of 1000 dollars by issuing both the securities that is debt and equity. So in this scenario we can draw a conclusion as a result that a firm is indifferent between these two choices of capital structure as the both of these two choices of capital structure are yielding an equal amount of 1000 dollars to the firm.