NET OPERATING INCOME APPROACH - Accounts and Finance for Managers

This another approach developed by Durand, which has underlying principle that the application of leverage do not have any influence on the value of the firm through the overall cost of capital. The more application of leverage leads to bring down the explicit cost of capital on one side and on the other side implicit cost of debt is expected to go up. How the implicit cost of debt will go up? The more application of debt leads to increase the financial risk among the investors, that warranted the equity share holders to bear additional financial risk of the firm. Due to additional financial risk, the share holders are requiring the firm to pay additional dividends over the existing. The increase in the expectations of the shareholders with reference to dividends hiked the cost of equity.

Under this approach, no capital structure is found to be a optimum capital structure. The major reason is that the debt-equity ratio does not influence the cost of overall capital, which always nothing but remains constant.

It is finally concluded that this approach highlights that application of leverage never makes an attempt to enhance the value of the firm, in other words which is known as unaffected by the application of leverage.

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