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:
 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:
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)
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
Equitycapitalization 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%
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 repurchase 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
Equitycapitalization 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.
Online Live Tutor Net Operating Income Approach:
We have the best tutors in Finance in the industry. Our tutors can break down a complex
Net Operating Income Approach problem into its sub parts and explain to you in detail how
each step is performed. This approach of breaking down a problem has been appreciated by
majority of our students for learning Net Operating Income Approach concepts. You will
get onetoone personalized attention through our online tutoring which will make learning
fun and easy. Our tutors are highly qualified and hold advanced degrees. Please do send us
a request for Net Operating Income Approach tutoring and experience the quality yourself.
Online Degree of Effect of Change in Capital Structure on NOI Help:
If you are stuck with a Degree of Effect of Change in Capital Structure on NOI Homework
problem and need help, we have excellent tutors who can provide you with Homework Help.
Our tutors who provide Degree of Effect of Change in Capital Structure on NOI help are
highly qualified. Our tutors have many years of industry experience and have had years
of experience providing Degree of Effect of Change in Capital Structure on NOI Homework
Help. Please do send us the Degree of Effect of Change in Capital Structure on NOI problems
on which you need Help and we will forward then to our tutors for review.
Other topics under Capital Structure Theories: