(^264) Financial Management
- This means that as we increase the level of debt in the company, the value of the
firm would go up even further. This would mean that the companies would like
to employ as much debt as possible. Something that doesn't happen in the real
world. - Note that we have not considered the effect of taxes. If we consider the same,
the value of the firm would go up even further because of the interest tax shield,
an effect that we consider later.
Net Operating Income Approach
Taking an opposite view from the view taken in the net income approach, this approach
states that the cost of capital for the whole firm remains constant, irrespective of the
leverage employed in the firm. With the cost of debt and the cost of capital constant,
we can say that the cost of equity capital changes with the leverage to compensate for
the additional level of risk.
Putting it simply, according to the net operating income approach; for all degrees of
leverage,
l Overall capitalisation rate remains constant
l The cost of debt remains same
Given this, and manipulating the equation of the firm's total cost of capital, we can
express the cost of equity as:K K
K k D
e o D E
= + o- d
+( ) *
( )
This is illustrated below in Figure 11.2.Figure 11.2: Graph of Net Opearting Income Approach