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CS Executive · Corporate Accounting and Financial Management · Operational Approach to Financial Decision

Which assumption is characteristic of the traditional approach to capital structure but NOT of the Net Operating Income approach?

The traditional approach holds that the overall cost of capital first declines with moderate leverage and later rises as financial risk increases, so an optimal capital structure exists. The NOI approach instead says Ko stays constant and value is independent of leverage.

  1. ACost of capital falls up to a point, then rises, giving an optimal capital structureCorrect
  2. BCost of debt remains constant at all leverage levels
  3. COverall cost of capital remains constant at all leverage levels
  4. DMarket value of the firm is independent of capital structure

Explanation

The traditional approach holds that moderate debt lowers Ko, but excessive debt raises both Ke and Kd, so Ko follows a U shape and an optimal structure exists. Options C and D are NOI/MM views; B is not unique to the traditional view.

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