Critical evaluation of the NI and NOI approaches

Net income (NI) approach

The view. A firm can lower its weighted average cost of capital and raise its value, and the market price of its shares, by using as much debt as possible. The costs of debt (kd) and equity (ke) stay constant whatever the leverage, and kd < ke, so replacing equity with cheaper debt lowers ko. Assumptions: kd < ke; no taxes; investors' perception of risk is not changed by the use of debt.

Evaluation.

• Merits: simple; correctly recognises that debt is the cheaper source and that, within limits, it can lower the cost of capital (the basis of trading on equity).
• Criticism: its central assumption is unrealistic. As debt rises, the shareholders bear more financial risk and demand a higher return, so ke cannot stay constant; lenders too charge more at high leverage. Taken literally, the approach implies that the firm should use debt to the maximum possible extent; ko approaches kd but never reaches it, as a firm can never be 100% debt-financed.

Net operating income (NOI) approach

The view. Suggested by Durand, it is the opposite extreme: a change in capital structure does not affect the value of the firm, and the overall cost of capital stays the same whatever the debt-equity mix. The market capitalises the firm as a whole, business risk is constant, and the advantage of cheaper debt is exactly offset by the rise in the cost of equity as financial risk increases. So there is no optimal capital structure: every structure is optimal.

Evaluation.

• Merits: it recognises that leverage raises the shareholders' risk and their required return; its conclusion was later given a behavioural justification by Modigliani and Miller, who support the NOI approach through the arbitrage argument.
• Criticism: the exact offset is assumed, not proved; it ignores taxes, under which the deductibility of interest makes debt valuable; it assumes kd constant at every level of debt, whereas lenders charge more as risk rises; and it ignores bankruptcy costs. In practice firms do seek a target capital structure.

Overall assessment

Both are extreme positions. The traditional approach strikes a balance: moderate debt lowers ko up to a point, beyond which rising risk raises it, giving an optimal capital structure. This middle view, and MM with taxes, describe actual firms better than either extreme.