The correct answer is: C. Modigliani-Miller Approach
The Modigliani-Miller Approach, also known as the MM Approach, is a theory that states that the value of a firm is not affected by its capital structure. This means that the costs of equity capital and debt capital remain unaltered when the degree of leverage varies.
The MM Approach is based on the following assumptions:
- There are no taxes.
- There are no transaction costs.
- There are no bankruptcy costs.
- Investors are rational and have homogeneous expectations.
- There are no information asymmetries between investors and managers.
Under these assumptions, the MM Approach shows that the value of a firm is equal to the present value of its expected future cash flows, regardless of its capital structure. This is because the costs of equity capital and debt capital are equalized by the tax shield on debt interest.
However, the MM Approach has been criticized for its unrealistic assumptions. In reality, there are taxes, transaction costs, bankruptcy costs, and information asymmetries. These factors can affect the value of a firm and make the MM Approach less relevant.
Despite its limitations, the MM Approach is an important theory in corporate finance. It provides a foundation for understanding the relationship between capital structure and firm value.
The other options are incorrect because they do not advocate that the costs of equity capital and debt capital remain unaltered when the degree of leverage varies.
- A. Net Income Approach is a method of calculating the cost of capital that uses net income as the starting point. This approach is based on the assumption that the cost of capital is equal to the return on equity. However, this assumption is not always accurate, as the cost of capital can be affected by other factors, such as the risk of the investment.
- B. Traditional Approach is a method of calculating the cost of capital that uses the weighted average cost of capital (WACC). The WACC is calculated by taking a weighted average of the costs of equity capital and debt capital. The weights are based on the proportions of equity and debt in the firm’s capital structure. However, the WACC can be inaccurate, as it does not take into account the risk of the investment.
- D. Net operating Income is a measure of a firm’s profitability that is calculated by taking the firm’s operating income and dividing it by its total assets. Net operating income is a useful measure of a firm’s ability to generate cash flow, but it does not take into account the firm’s capital structure.