Compare and contrast the “net income approach,” “net operating income approach,” and “traditional approach” to the optimal debt-equity mix. Which assumptions do you find reasonable? Unreasonable?
The net income approach, net operating income approach, and traditional approach are three theoretical frameworks for how a company should set its debt-equity mix. All three examine how a company’s cost of capital changes with the debt-equity mix and search for the lowest value of the cost of capital, hence the maximum value of the firm, to identify the best mix. They reach different conclusions because they make different assumptions about creditors’ and investors’ reactions to increasing debt. Each of us will have our own feelings about the reasonableness of the assumptions. Without going into the Modigliani-Miller mathematics, the assumptions of the traditional approach usually seem most reasonable to most people.
(1) The net income approach makes the simplest assumptions, that neither creditors nor investors increase their required rates of return as a company takes on debt. The cost of capital declines as higher-cost equity is replaced with lower-cost debt. This approach concludes that the optimal financing mix is all debt.
(2) The net operating income approach assumes that creditors do not increase their required rate of return as a company takes on debt, but investors do. Further, the rate at which investors increase their required rate of return as the financing mix is shifted toward debt exactly offsets the weighting away from the more expensive equity and toward the cheaper debt. The result is that the cost of capital remains constant regardless of the financing mix. This approach concludes that there is no optimal financing mix¾any mix is as good as any other.
(3) The traditional approach assumes that both creditors and investors increase their required rates of return as a company takes on debt. At first this increase is small, and the weighting toward lower-cost debt pushes the cost of capital down. Eventually, the rate at which creditors and investors increase their required rates of return accelerates and dominates the weighting toward debt, pushing the cost of capital back upward. The result is that the cost of capital declines with debt and reaches a minimum point before rising again. This approach concludes that there is a optimal financing mix consisting of some debt and some equity.