## NI vs NOI Approach to Capital Structure

Two of the classic approaches to capital structure differ fundamentally on whether the financing mix affects the value of the firm (VF).

### Net Operating Income (NOI) Approach

Capital structure decisions are irrelevant — VF and the overall cost of capital (KO) stay constant regardless of the debt level.
Why KO stays constant: The low-cost advantage of using cheaper debt is exactly offset by a rise in the cost of equity (Ke). Equity investors demand a higher return as financial risk increases, neutralising the benefit of cheap debt.
Net effect: no change in VF.

### Behaviour of the key variables when debt increases

Approach	Kd (cost of debt)	Ke (cost of equity)	KO (overall cost)	VF (value of firm)
NI	Constant	Constant	Decreases	Increases
NOI	Constant	Increases	Constant	Constant

### Reading the table

Under NI, since both Kd and Ke are held constant and debt is cheaper, adding more (cheaper) debt pulls KO down and pushes VF up — so capital structure is relevant.
Under NOI, Ke rises to absorb the debt benefit, so KO and VF are flat — capital structure is irrelevant.

⚠️ Common exam mistakes

Thinking Ke stays constant under the NOI approach — it actually rises with more debt, which is precisely what keeps KO constant.
Confusing which approach makes capital structure relevant: NI makes it relevant (VF changes), NOI makes it irrelevant (VF constant).
Forgetting that under both approaches Kd is assumed constant; the difference lies in Ke's behaviour.

Reference:

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Net Income (NI) vs Net Operating Income (NOI) Approach

⚠️ Common exam mistakes