Page 135 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 7: Capital Structure Decision

the overall cost of capital, WACC. The financing mix or the capital structure is irrelevant and Notes
does not affect the value of the firm. The NOI approach makes the following assumptions:
1. Investors see the firm as a whole and thus capitalize the total earnings of the firm to find
the value of the firm as a whole.
2. The overall cost of capital of the firm is constant and depends upon the business risk,
which also is assumed to be unchanged.
3. The cost of debt is also taken as constant.
4. The use of more and more debt in the capital structure increases the risk of shareholders
and thus results in the increase in the cost of equity capital i.e., the increase in cost of equity
is such, as to completely offset the benefits of employing cheaper debt, and
5. There is no tax.

The NOI approach is based on the argument that the market values the firm as a whole for a
given risk complexion. Thus, for a given value of EBIT, the value of the firm remains the same,
irrespective of the capital composition and instead depends on the overall cost of capital. The
value of the equity may be found by deducting the value of debt from the total value of the firm
i.e.,
EBIT
V =
Ko
E = Value of equity
V = Value of firm.

D = Market value of debt
And E = V–D
And the cost of equity capital, Ke, is

EBIT Interest
-
Ke =
V D
-
Thus, the financing mix is irrelevant and does not affect the value of the firm. The value remains
same for all types of debt-equity mix. Since there will be change in risk of the shareholders as a
result of change in debt-equity mix, therefore, the Ke will be changing linearly with change in
debt proportions. The NOI approach to the relationship between the leverage and cost of capital
has been presented in the following figure.
Figure 7.3: NOI Approach

The above diagram shows that the cost of debt, Kd, and the overall cost of capital Ko are constant
for all levels of leverage. As the debt proportion or the financial leverage increases, the risk of

LOVELY PROFESSIONAL UNIVERSITY 129