Page 136 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes the shareholders remains constant because increase in Ke is just sufficient to off set the benefits
of cheaper debt financing.
The NOI approach considers Ko to be constant and therefore, there is no optimal capital structure
as good as any other and so every capital structure is an optimal one. The NOI approach can be
illustrated with an example.

Example: A firm has an EBIT of 200,000 and belongs to a risk class of 10%. What is the
value of cost of equity capital, if it employs 6% debt to the extent of 30%, 40% or 50% of the total
capital fund of 10,00,000?
Solution:

The effect of changing debt proportion on the cost of equity capital can be analyzed as follows:

The NI and the NOI approach hold extreme views on the relationship between the leverage, cost
of capital and the value of the firm. In practical situations, both these approaches seem to be
unrealistic. The traditional approach takes a compromising view between the two and
incorporates the basic philosophy of both. It takes a midway between the NI approach (that the
value of the firm can be increased by increasing the leverage) and the NOI approach (that the
value of the firm is constant irrespective of the degree of financial leverage).
The traditional viewpoint states that the value of the firm increases with increase in financial
leverage but only up to a certain limit. Beyond this limit, the increase in financial leverage will
increase its WACC and hence the value of the firm will decline.
Under the traditional approach, the cost of debt is assumed to be less than the cost of equity. In
case of 100% equity firm, overall cost of the firm is equal to the cost of equity, but, when
(cheaper) debt is introduced in the capital structure and the financial leverage increases, the cost
of equity remains the same as the equity investors expect a minimum leverage in every firm.
The cost of equity does not increase even with increase in leverage. The argument for Ke
remaining unchanged may be that up to a particular degree of leverage, the interest charge may
not be large enough to pose a real threat to the dividend payable to the shareholders. This
constant Ke and Kd makes the Ko to fall initially. Thus, it shows that the benefits of cheaper
debts are available to the firm. But this position does not continue when leverage is further
increased.

The increase in leverage beyond a limit increases the risk of the equity investors too and as a
result the Ke also starts increasing. However, the benefits of use of debt may be so large that
even after offsetting the effects of increase in Ke, the Ko may still go down or may become
constant for some degree of leverages.

However, if the firm increases leverage further, then the risk of the debt investor may also
increase and consequently the Kd of debt also starts increasing. The already increasing Ke and

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