The essence of the NI approach is that the firm can increase its value or lower the overall cost of capital by increasing the proportion of debt in the capital structure. The crucial assumption of this approach are:

(a) The use of debt does not change the risk perception of the investor. Thus Kd and Ke remain constant with changes in leverage.

(b) The debt capitalization rate is less than equity capitalization rate (i.e. Kd < Ke).

The implications of these assumptions are that with constant Kd and Ke, increased use of debt, by magnifying the shareholders earnings will result in a higher value of the firm via higher value of equity. The overall cost of capital will therefore decrease. If we consider the equation for the overall cost of capital,


Ko decreases as D/V increases because Ke and Kd are constant as per our assumptions and Kd is less than Ke. This also implies that Ko will be equal to Ke if the firm does not employ any debt (i.e. when D/V = 0) and that Ko will approach Kd as D/V approaches 1.