Page 102 - DMGT409Basic Financial Management

Unit 6: Capital Structure Theory

NOI approach can be graphically shown as below: Notes

K , K , K %
e
o
d
K
e
K o

K d
0.5
1.0
0 Degree of leverage

From the above graph, it is clear that, as the degree of leverage is increased, Ko and Kd remains
at the same level. But cost of equity increases with leverage and exactly neutralises the benefi ts of
low cost debt. So overall cost of Capital remains at the same level.

6.4 Traditional or Intermediate Approach or WACC Approach

This approach is midway between the NI and the NOI approach. The main propositions of this
approach are:

1. The cost of debt remains almost constant upto a certain degree of leverage but rises
thereafter, at an increasing rate.
2. The cost of equity remains more or less constant or rises gradually up to a certain degree of
leverage and rises sharply thereafter.
3. The cost of capital due to, the behaviour of the cost of debt and cost of equity, decreases
upto a certain point and remains more or less constant for moderate increases in leverage,
thereafter, rises beyond that level at an increasing rate.
The figure given below describes the traditional Viewpoint on the Relationship between Leverage,

Cost of Capital and Value of the form:

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