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

Under the net income (NI) approach to capital structure, as a firm increases the proportion of debt (with cost of debt lower than cost of equity), the overall cost of capital:

Under the net income approach, the overall cost of capital falls as debt rises, so firm value increases. Both the cost of debt and the cost of equity are assumed constant, so cheaper debt simply lowers the weighted average cost.

  1. AIncreases
  2. BDecreases, so value of the firm increasesCorrect
  3. CRemains constant
  4. DFirst rises, then falls

Explanation

NI approach assumes cost of debt and cost of equity remain constant as leverage rises. Substituting cheaper debt for equity lowers the weighted average cost of capital, thereby raising firm value. Hence the optimal structure is maximum debt.

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