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

Which of the following is a feature of the Net Operating Income (NOI) approach to capital structure?

In the Net Operating Income approach, the overall cost of capital is constant, so the firm's market value does not depend on its capital structure. Extra debt raises the cost of equity by an offsetting amount, so there is no optimal mix.

  1. AThe market value of the firm is independent of its capital structureCorrect
  2. BThe cost of debt rises as the firm increases leverage but equity cost stays constant
  3. CThe value of the firm increases with leverage because debt is cheaper
  4. DThere is an optimal capital structure at a specific debt level

Explanation

NOI (Durand) assumes overall cost of capital is constant and the market capitalises the whole firm's EBIT at Ko. Any extra debt raises the cost of equity to offset its cheapness, so value is unaffected by leverage. The other options describe NI or traditional views.

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