Cost of Debt

The cost of debt (k) has two parts: (a) Explicit cost which is represented by the rate of interest. Irrespective of the degree of leverage the firm is assumed to he able to borrow at a given rate of interest. This implies that the increasing proportion of debt in the financial structure does not affect the financial risk of the lenders and they do not penalize the firm by charging higher interest; (b) Implicit or hidden cost. As shown in the assumption relating to the changes in ke increase in the degree of leverage or the proportion of debt to equity causes an increase in the cost of equity capital. This increase in ke being attributable to the increase in debt, is the implicit part of ke.

Thus, the advantage associated with the use of debt, supposed to be a cheaper source of funds in terms of the explicit cost, is exactly neutralized by the implicit cost represented by the increase in ke. As a result, the real cost of debt and the real cost of equity, according to the NOI Approach, are the same and equal ko.

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