The Net Operating Income approach is the opposite of the Net Income approach to capital structure. With this approach, any change in leverage will not necessarily affect the market value of shares.
Another theory of capital structure, as suggested by ‘Durand2’ is the Net Operating Income (NOI) Approach. This Approach is diametrically opposite to the NI Approach. The essence of this Approach is that the capital structure decision of a firm is irrelevant. Any change in leverage will not lead to any change in the total value of the firm and the market price of shares as well as the overall cost of capital is independent of the degree of leverage
Net Operating Income Approach
Net Operating Income Approach was also suggested by Durand. This approach is of the opposite view of Net Income approach. This approach suggests that the capital structure decision of a firm is irrelevant and that any change in the leverage or debt will not result in a change in the total value of the firm as well as the market price of its shares. This approach also says that the overall cost of capital is independent of the degree of leverage.
Features of NOI approach:
Value of Equity = Total value of the firm - Value of debt
Example:
Let us assume that a firm has an EBIT level of $50,000, cost of debt 10%, the total value of debt $200,000 and the WACC is 12.5%. Let us find out the total value of the firm and the cost of equity capital (the equity capitalization rate).
Solution:
EBIT = $50,000
WACC (overall capitalization rate) = 12.5%
Therefore, total market value of the firm = EBIT/Ko ⇒ $50,000/12.5% ⇒ $400,000
Total value of debt =$200,000
Therefore, total value of equity = Total market value - Value of debt
⇒ $400,000 - $200,000 ⇒ $200,000
Cost of equity capital = Earnings available to equity holders/Total market value of equity shares
Earnings available to equity holders = EBIT - Interest on debt
⇒ $50,000 - (10% on $200,000) ⇒ $30,000
Therefore, cost of equity capital = $30,000/$200,000 ⇒ 15%
Verification of WACC:
10% x ($200,000/$400,000) + 15% x ($200,000/$400,000) ⇒ 12.5%
Net Income (NI) Approach
Net Income theory was introduced by David Durand. According to this approach, the capital structure decision is relevant to the valuation of the firm. This means that a change in the financial leverage will automatically lead to a corresponding change in the overall cost of capital as well as the total value of the firm. According to NI approach, if the financial leverage increases, the weighted average cost of capital decreases and the value of the firm and the market price of the equity shares increases. Similarly, if the financial leverage decreases, the weighted average cost of capital increases and the value of the firm and the market price of the equity shares decreases.
Assumptions of NI approach:
Example
A company expects its annual EBIT to be $50,000. The company has $200,000 in 10% bonds and the cost of equity is 12.5(ke)%.
Calculation of the Value of the firm:
Effect of change in the capital structure: (Increase in debt capital)
Let us assume that the firm decides to retire $100,000 worth of equity by using the proceeds of new debt issue worth the same amount. The cost of debt and equity would remain the same as per the assumptions of the NI approach. This is because one of the assumptions is that the use of debt does not change the risk perception of the investors.
Calculation of new value of the Firm
Please note:
Overall cost of capital can also be calculated by using the weights of debt and equity contents with the respective cost of capitals.
This proves that the use of additional financial leverage (debt) causes the value of the
firm to increase and the overall cost of capital to decrease
Capital Structure.... Gearing??? I've never heard of that one.
The operating cycle approach to working capital includes four key events. They are purchase of raw materials, payment for purchase, sale of unfinished goods and collection of cash for sold goods.
Capital structure which aims at the maximization of profits. It is related to text planning in that planning help evaluate the the theories of capital structure.
International Financial Management is operating outside of the domestic boarding.
net operating capital net operating capital
capital structure decisions are structure with decisions
The objective of capital structure is minimize the WACC cost.
elements of capital structure
The traditional view of a firms capital structure is the process of increasing goodwill value of the firm, while limiting the use of capital expenses and controlling capital costs. The first achieves this through materializing its limited finances through financial leverage.
The dividend decision is made jointly with the capital structure and capital budgeting decisions because all three decisions are interconnected and have an impact on the overall financial position of the company. The dividend decision determines how much of the company's earnings are distributed to shareholders, which in turn affects the company's ability to finance its capital structure and fund capital budgeting projects. By considering all three decisions together, companies can ensure a balanced approach that aligns with their overall financial goals and objectives.
Damascus
optimal capital structure means using the resources of capital optimally, at is where they can utilised properly. target capital structure means investment made in the certain project so that they can utilise the resource of capital properly.