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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 happens when a firm raises the proportion of debt in its capital structure?

Under the Net Income approach, the cost of debt and equity are assumed constant, and debt is cheaper than equity. Raising the debt proportion therefore lowers the overall cost of capital and increases firm value, with value maximised at very high debt. Constant WACC is the NOI view, and a U-shape is the traditional view.

  1. AThe overall cost of capital falls and the value of the firm risesCorrect
  2. BThe overall cost of capital rises and the value of the firm falls
  3. CThe overall cost of capital stays constant at every debt level
  4. DThe overall cost of capital first falls and then rises, giving a U-shaped curve

Explanation

The NI approach assumes that the cost of debt and the cost of equity stay constant as leverage changes. Debt is cheaper than equity, so a higher debt share lowers the weighted average cost of capital and raises firm value. Constant WACC is the Net Operating Income approach, and a U-shaped WACC belongs to the traditional approach.

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