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Assumptions

The proposition that the weighted average cost of capital is constant irrespective of the type of capital structure is based on the following assumptions:

(a) Perfect capital markets. The implication of a perfect capital market is that (i) securities are infinitely divisible; (ii) investors are free to buy/sell securities, (iii) investors can borrow without restrictions on the same terms all conditions as firms can; (iv) there are no transaction costs; (v) information is perfect, that is, each investor has the same information which is readily available to him without cost; and (vi) investors are rational and behave accordingly.

(b) Given the assumption of perfect information and rationality, all Investors have the same expectation of firm’s net operating Income (EBIT) with which to evaluate the value of a firm.

(c) Business risk is equal among all firms within similar operating environment. That means, all firms can be divided into equivalent risk class or homogeneous risk class. The term equivalent/homogeneous risk class means that the expected earnings have identical risk characteristics. Firms within an industry are assumed to have the same risk characteristics. The categorization of firms into equivalent risk class is on the basis of the industry group to which the fum belongs.

(d) The dividend payout ratio is 100 per cent.

(e) There are no taxes: This assumption is removed later.

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