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Net Operating Income Approach

capital structure Assignment / Homework Help
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:

  • 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.

  • 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

  • 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%

Effect of change in Capital structure (to prove irrelevance)

Let us now assume that the leverage increases from $200,000 to $300,000 in the firm's capital structure. The firm also uses the proceeds to re-purchase its equity stock so that the market value of the firm remains the same at $400,000.


EBIT = $50,000

WACC = 12.5% (overall capitalization rate)

Total market value of the firm = $50,000/12.5% ⇒ $400,000

Less: Total market value of debt ⇒ $300,000

Therefore, market value of equity = $400,000 - $300,000 ⇒ $100,000

Equity-capitalization rate = ($50,000 - [10% on $300,000)/$100,000 ⇒ 20%

Overall cost of capital =

10% x $300,000/$400,000 + 20% x $100,000/$400,000 ⇒ 12.5%

The above example proves that a change in the leverage does not affect the total value of the firm, the market price of the shares as well as the overall cost of capital.


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