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CS Executive · Corporate Accounting and Financial Management · Capital Structure

Under the Net Income approach to capital structure, what happens to the overall cost of capital and value of the firm as the proportion of debt is increased, assuming cost of debt is lower than cost of equity and both remain constant?

Under the Net Income approach, increasing debt lowers the weighted average cost of capital because cheaper debt gets more weight while component costs stay constant. Firm value therefore rises, and the optimal structure is almost entirely debt.

  1. AWACC rises and firm value falls
  2. BWACC falls and firm value risesCorrect
  3. CWACC and firm value stay unchanged
  4. DWACC stays constant while firm value rises

Explanation

Under the Net Income approach, cost of debt and cost of equity stay constant as leverage rises. Cheaper debt gets a larger weight, so WACC falls continuously and firm value increases. Unchanged WACC and value is the Modigliani-Miller (without tax) or Net Operating Income view.

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