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CA Intermediate · Financial Management and Strategic Management · Financing Decisions - Capital Structure

According to the Net Income (NI) approach to capital structure, which of the following statements is correct when a firm replaces equity with cheaper debt?

Under the Net Income approach, cost of debt and cost of equity stay constant as leverage changes. Because debt is cheaper than equity, more debt lowers the overall cost of capital and increases the value of the firm, so the optimal structure is almost entirely debt.

  1. AThe overall cost of capital rises and the value of the firm falls
  2. BThe overall cost of capital falls and the value of the firm risesCorrect
  3. CThe overall cost of capital and the value of the firm remain unchanged
  4. DThe cost of equity rises enough to fully offset the benefit of debt

Explanation

Under the NI approach, the cost of debt and the cost of equity are assumed constant when leverage changes. Since debt is cheaper than equity, a higher proportion of debt lowers the weighted average cost of capital and raises the firm's value. Option C and D describe the Net Operating Income and Modigliani-Miller (no tax) views.

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