The Net Operating Income Approach suggests that a firm's capital structure and use of leverage is irrelevant to the total value or market price of the firm. It also claims that the overall cost of capital remains constant regardless of leverage. Key assumptions are that there are no taxes, debt costs remain constant, and the overall cost remains constant. An example shows that even if leverage increases from $200k to $300k debt, the total firm value, stock price, and overall cost of capital remain the same at $400k, proving the approach's claim of irrelevance.

1. Financial Management(KMB204)
Theories of Capital Structure(Part2)
Net Operating Income Approach
Prepared by :
Taru Maheshwari
Sr.Asstt.Prof. ABESEC
AKTU (Lucknow)

2. 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.

3. Features
• At all degrees of leverage (debt), the overall capitalization rate would
remain constant.
• 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.

4. Assumptions
(i) There are no corporate taxes.
(ii) Cost of debt remains constant at all level of debt.
(iii) Overall cost of capital remains constant.

5. Example
• 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%

6. 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.