The Net Operating Income approach suggests that the value of a firm does not depend on its overall cost of capital. It values the firm based solely on its earnings before interest and taxes (EBIT) divided by the overall capital rate. The approach assumes no corporate taxes, debt-equity mix does not affect overall cost of capital, and the overall cost of capital is constant. An example shows that as the amount of debt changes, affecting the equity and cost of equity, the overall value of the firm remains the same at different debt levels under this approach.

1. Net Operating Income
Approach
By MANAS DHIBAR

2. Introduction
 While Net Income Approach concluded that Capital
Structure makes a difference to the Value of the Firm,
the Net Operating Income Approach suggests that value
of the firm does not depend upon the Overall Cost of
Capital. It is quite opposite to the Net Income Approach.
According to which the earnings before interest & taxes
determined the Value of the Firm.
 In this theory the advantage of debt is affected by
increase in Equity Capitalisation Rate.

3.  V = EBIT
Ke
 E = V – D
 V = Value of the Firm
 EBIT = Earning Before Interest & Tax.
 Ke = Overall Capital Rate
 D = Debentures
 E = Overall Cost of Capital

4. Assumptions of This Approach
 There are no Corporate Taxes.
 The Debt Equity mix does not effect the Overall Cost of Capital.
 The increase in Debt changes the risk perception of the
Shareholder.
 Overall Cost of Capital is Constant. It is dependent on the business
risk which is also constant.
Durand explains that when debt increases there is the increase in
interest burden of the company & when interest increase
shareholders began to expect the higher return from the company.
This increases the cost of equity & overall value of the firm does not
gain increase in debt proportion of the firm.

5. Example:-
 Net Operating of the Firm (EBT) = Rs 1,00,000.
 Overall Capital Rate = 10%
 Outstanding Debt Rs 2,00,00󠇀0 with 8% Cost of Debt.
CASE I.
V = 1,00,000 *100/10
= Rs 10,00,000
E = 10,00,000 – 2,00,000
= Rs 8,00,000
Ke = 1,00,000 – 16,000
10,00,000-2,00,000
= 84,000/8,00,000 = 10.5%

6.  CASE II. Debentures increases from 2,00,000 to 3,00,000.
V = 1,00,000 * 100/10
= Rs 10,00,000
E = V – D
= 10,00,000 – 3,00,000
= Rs 7,00,000
Ke = 1,00,000 – 24,000
10,00,000 – 3,00,000
= 76,000
7,00,000
=10.8%

7.  CASE III. Debentures decreases to 1,00,000.
V = 1,00,000 * 100/10
= Rs 10,00,000
E = 10,00,000 – 1,00,000
= Rs 9,00,000
Ke = 1,00,000 – 8,000
10,00,000 – 1,00,000
= 92,000
9,00,000
= 10.2%
Conclusion:- In all the three cases the value of the firm remains
the same.

8. Thank
You