Traditional and net operating income approaches to capital structure

1. Traditional approach

• Also called the intermediate approach, a compromise between the net income and net operating income approaches.
• Stage 1: as cheaper debt is introduced, the overall cost of capital (ko) falls and the value of the firm rises, because the saving from debt exceeds any rise in the cost of equity.
• Stage 2: beyond a point, increasing debt raises the financial risk of equity shareholders, so ke rises and offsets the advantage of cheap debt; ko stays roughly constant over a moderate range.
• Stage 3: with still more debt, the rise in ke (and even in kd, as lenders see more risk) outweighs the advantage, so ko rises and the value of the firm falls.
• Implication: there is an optimum capital structure (a point or range of leverage) at which ko is lowest and the value of the firm highest; capital structure is relevant.

2. Net operating income (NOI) approach

• Suggested by Durand; the opposite extreme of the net income approach.
• Assumptions: the market capitalises the value of the firm as a whole at the overall rate ko; business risk is constant at every debt-equity mix; kd is constant.
• Argument: using more of the cheaper debt raises the financial risk of equity shareholders, so ke rises by exactly enough to offset the advantage of the cheaper debt.
• Implication: ko and the value of the firm are constant whatever the debt-equity mix; there is no optimum capital structure, every structure being equally good; capital structure is irrelevant.

Comparison. Both agree that ke rises with leverage. Under NOI the rise exactly offsets cheap debt at every level, so ko never changes; under the traditional approach it does not at first, so moderate debt lowers ko and an optimum exists.