Question
Explain the Net Income (NI) and Net Operating Income (NOI) approaches with respect to capital structure. How do these approaches explain the relationship between leverage, cost of capital, and value of the firm?
Answer :
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The Net Income (NI) and Net Operating Income (NOI) approaches are two fundamental theories in financial management that analyze the impact of capital structure on a firm’s overall value and cost of capital. Both approaches provide insight into how the mix of debt and equity financing influences the financial risk, the cost of capital, and ultimately the valuation of the firm, but they differ significantly in their assumptions and implications. The Net Income approach, also known as the traditional approach, assumes that the overall value of the firm can be increased by using debt in the capital structure due to the lower cost of debt compared to equity. According to this approach, debt financing is cheaper because interest payments are tax-deductible, which reduces the firm’s taxable income. As a result, the weighted average cost of capital (WACC) decreases as the proportion of debt increases up to a certain optimal point. The NI approach posits a positive relationship between financial leverage and the firm’s value. This means that, by judiciously increasing debt, a firm can lower its overall cost of capital, increase earnings per share, and enhance the firm’s market value. The assumption here is that the
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