Net Operating Income Approach

According to this approach, the overall capitalisation rate or weighted average cost of capital and cost of debt capital remains constant whatever be the degree of leverage. This theory holds that the financing mix or capital stracture is irrelevent and does not affect the value of the firm. It suggests that any changes in the debt equity mix does not effect the value of the firm. Therefore. As per this approach, there is no one optimal capital stracture. Every capital stracture is optimal capital stracture. This theory advocates exactly the opposite of what has been advocated by Net Income approach. The assumptions are as follows : a) The cost of equity remains constant and is not affected by any change in the debt equity mix. b) The increase in the cost of debt financing is squared off against the increase in the return to equity shareholders. c) Corporate income tax does not exist. d) The debt capitalisation rate is constant. e) The overall cost of capital is constant and depends upon the business risk which is assumed to remain unaltered. f) The market capitalises the total earnings of the firm to determine the value of the firm as a whole. Therefore, the net operating income approach suggests : i) The cost of equity capital increases with the increase in the degree of leverage ; the reason being that the debt capital is cheaper and in case of weighted average cost of capital remaining constant, the cost of equity capital will increase. ii) The total value of the firm remains unaffected by the degree of leverage. It depends on the net operating income and business risk. iii) The market price of the share remains the same and is not affected by the firms capital stracture.
The NOI approach to cost of capital

Ke

Ko

Kd

Leverage(degree)

The fig. Shows that the cost of debt Kd , and the overall cost of capital, Ko , are constant for all leavels of leverage. As the debt proportion or the financial leverage increases, the risk of the shareholders also increases and thus the cost of equity capital, Ke also increases. The NCI approach considers Ko to be constant and therefore, there is no optimal capital stracture ; rather every capital stracture is good as any other and so every capital stracture is an optimal one. RAJIB BARUA PGDM 2011 NSHM BUSINESS SCHOOL