The critical assumptions of this approach are:

  1. The market capitalizes the value of the firm as a whole.

  2. Ko depends on the business risk. If the business risk is assumed to remain constant, then Ko will also remain constant.

  3. The use of less costly debt increases the risk of the shareholders. This causes Ke to increase and thus offset the advantage of cheaper debt.

  4. Kd is assumed to be constant.

  5. Corporate income taxes are ignored.