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

Which statement about the Net Operating Income (NOI) approach to capital structure is correct?

Under the NOI approach, overall cost of capital stays constant at every degree of leverage, and the cost of equity rises as debt grows to offset cheaper debt. Therefore firm value does not change and no optimal capital structure exists.

  1. ACost of equity falls as debt increases, so overall cost of capital falls
  2. BOverall cost of capital is constant at all leverage levels, and cost of equity rises linearly with debt-equity ratioCorrect
  3. CValue of the firm rises as debt is added because debt is cheaper
  4. DThere is an optimal capital structure at which Ko is minimum

Explanation

NOI (Durand) assumes Ko and cost of debt are constant, so the cost of equity must rise with leverage to offset cheaper debt. Hence value of the firm does not change and no optimal structure exists. The other options describe the Net Income or traditional approach.

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