NET OPERATING INCOME

APPROACH


 ROOPESH M
 S2 MBA

 IMK KOLLAM
 INTRODUCTION
 The capital structure should be examined
from the view point of its impact on the
value of the firm. It can be legitimately
expected that if the capital structure
decision affects the total value of the firm,
a firm should select such a financing mix
as will maximize the shareholders wealth.
Such a capital structure is referred to as
the optimum capital structure. The
optimum capital structure may be defined
as the capital structure or combination of
debt and equity that leads to the
maximum value of the firm.
 CAPITAL STRUCTURE
THEORIES-Assumptions
There are only two sources of funds used
by a firm: perpetual risk less debt and
ordinary shares.
The dividend-payout ratio is 100. That is,
the total earnings are paid out as dividend
to the shareholders and there are no
retained earnings.
The total assets are given and do not
change .
The total financing remains constant. The
firm can change its degree of leverage
either by selling shares and use the
proceeds to retire debentures or by raising
more debt and reduce the equity capital.
The operating profits are not expected to
grow.
All investors are assumed to have the
same subjective probability distribution of
the future expected EBIT for a given firm.
Business risk is constant over time and is
assumed to be independent of its capital
structure and financial risk.
Perpetual life of the firm.
 THE MAJOR CAPITAL
STRUCTURE THEORIES
Net Income Approach
Net Operating Income Approach
Modigliani-Miller (MM) Approach
Traditional Approach
 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.
 THE NOI APPROACH IS BASED ON
THE FOLLOWING PROPOSITIONS
 Overall cost of capital\Capitalization
rate (Ko)is constant.
 The NOI Approach to valuation
argues that the overall capitalization
rate of the firm remains constant,for
all degree of leverage.The value of
the firm ,given the level of EBIT,is
determined by
 V=EBIT\Ko
 RESIDUAL VALUE OF EQUITY

 The value of equity is a residual

value which is determined by
deducting the total value of debt (B)
from the total value of the firm (V).

 Total market value of equity capital

(S)=V-B
 CHANGES IN COST OF EQUITY
 The equity-capitalization rate \cost of equity
capital (ke) increases with the degree of
leverage.The increase in the proportion of debt in
the capital structure relative to equity shares
would lead to an increase in the financial risk to
the ordinary shareholders. To compensate for the
increased risk, the shareholders would expect a
higher rate of return on their investments.The
increase in the equity capitalization rate would
increase in the debt-equity ratio.
 Ke=Ko +(Ko-K i) (B\S)
 COST OF DEBT
 The cost of debt (Ki) 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 be able to borrow at a
given rate of interest.
 (b)Implicit or hidden cost. As shown in the
assumption relating to the changes in
ke,increases in the degree of leverage or the
proportion of debt to equity causes an increase in
the cost of Equity. This increase in Ke,being
attributable to the increase in debt, is the implicit
part of Ke.
 .
 The real cost of debt and the real cost of
equity, according to the NOI Approach, are
the same and equal Ko.
OPTIMUM CAPITAL STRUCTURE
 The total value of the firm is unaffected by
its capital structure. No matter what the
degree of leverage is, the total value of
the firm will remain constant. The market
price of shares will also not change with
the change in the debt-equity ratio. There
is nothing such as an optimum capital
structure. Any capital structure is
optimum, according to the NOI Approach.