Final answer:
The NOI approach to firm valuation posits that the total value of a firm is unaffected by changes in its capital structure, as it relies on the firm's net operating income. Changes in leverage and the cost of equity offset each other, affirming the firm's value. The present discounted value of investments reflects investors' differing views on potential profits.
Step-by-step explanation:
NOI Approach to Firm Valuation and Capital Structure
According to the Net Operating Income (NOI) approach to firm valuation, the total value of the firm is not affected by changes in its capital structure. Instead, the value of the firm is determined by its ability to generate net operating income.
The underlying assumption of the NOI approach is that the firm's cost of equity is a linear function of its capital structure, meaning that as a firm increases its leverage, the cost of equity increases linearly, thus offsetting any gains from the tax shield of debt.
The NOI approach suggests that changing the capital structure doesn't create value in itself, because the increased financial risk from more debt is exactly offset by the lower-cost debt.
Therefore, even though cost of capital and the effective rate of return are critical components in evaluating investment opportunities and capital allocation, they don't directly affect the firm's total value under the NOI theory.
For practical purposes, financial investors may have differing opinions on a firm's future profitability, which influences their willingness to buy or sell stocks.
Calculations of present discounted value for bonds or stocks involve discounting the future benefits to their present value, which requires careful consideration of interest rates, capital gains, and dividend payments.