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

According to the Net Operating Income (NOI) approach to capital structure, what happens to the overall cost of capital (WACC) of a firm as it increases the proportion of debt in its capital structure?

Under the NOI approach the overall cost of capital stays constant whatever the debt proportion. The benefit of cheaper debt is exactly cancelled by the higher equity cost demanded for greater financial risk, so firm value is unaffected by capital structure.

  1. AIt falls continuously because debt is cheaper than equity
  2. BIt remains constant at all levels of debtCorrect
  3. CIt first falls and then rises after an optimal point
  4. DIt rises continuously because of the increasing cost of equity

Explanation

Under the NOI approach, the overall capitalisation rate is constant. Cheaper debt is exactly offset by a higher cost of equity as financial risk rises, so WACC and total firm value do not change with leverage. Option A describes the Net Income approach, and option C describes the Traditional approach.

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