The traditional approach

  • Ke increases as gearing increases due to rising financial risk and, later, bankruptcy risk.
  • Kd rises at high levels of gearing due to bankruptcy risk.
  • As company starts to replace expensive equity with cheaper debt, WACC falls.
  • As gearing continues to increase, Ke and Kd increase, offsetting the benefit of cheap debt.

Net income approach

  • Capital markets are assumed to be perfect.
  • No risk of bankruptcy so Kd curve is flat.
  • Linear increase in Ke due to increasing financial risk.
  • As company gears up and replaces equity with debt, benefit of cheaper debt is exactly balanced by the increasing cost of equity.
  • No optimal capital structure is found.
  • Arbitrage proof using companies A and B:


Net income 1000 1000

Interest at 5% Nil 150

Earnings 1000 850

Divide by cost of equity 10% 11%

MV of equity 10 000 7 727

MV of debt Nil 3 000

Total market value 10 000 10 727

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