Explain Net Operating Income approach to capital structure?

Answer 1

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.

Answer 2

Net Operating Income Approach By kiritharan100

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

Answer 3

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:

1. At all degrees of leverage (debt), the overall capitalization rate would remain constant. For a given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be equal to EBIT/overall capitalization rate.

1. The value of equity of a firm can be determined by subtracting the value of debt from the total value of the firm. This can be denoted as follows:

   Value of Equity = Total value of the firm - Value of debt

1. Cost of equity increases with every increase in debt and the weighted average cost of capital (WACC) remains constant. When the debt content in the capital structure increases, it increases the risk of the firm as well as its shareholders. To compensate for the higher risk involved in investing in highly levered company, equity holders naturally expect higher returns which in turn increases the cost of equity capital.

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:

1. There are no taxes
2. The cost of debt is less than the cost of equity.
3. The use of debt does not change the risk perception of the investors

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