NET OPERATING INCOME APPROACH

 NET OPERATIN INCOME APPROACH

This Approach is suggested by Durand. Net Operating Income Approach to capital structure believes that the value of a firm is not affected by the change of debt component in the capital structure. It assumes that the benefit that a firm derives by infusion of debt is negated by the simultaneous increase in the required rate of return by the equity shareholders.

Assumptions of Net Operating Income Approach

  1. The overall Capitalization Rate  remains constant irrespective of the degree of leverage. At a given level of EBIT, the value of the firm would be “EBIT/Overall capitalization rate.”
  2. Value of equity is the difference between total firm value and less value of debt, i.e., Value of Equity = Total Value of the Firm – Value of Debt.
  3. WACC (Weightage Average Cost of Capital) remains constant, and with the increase in debt, the cost of equity increases. An increase in debt in the Capital Structure results in increased risk for shareholders. As compensation for investing in the highly leveraged company, the shareholders expect higher returns resulting in a higher cost of equity capital.

Value of the firm/Cost of Equity (Formulae)



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