NET OPERATING INCOME NET OPERATING INCOME APPROACHAPPROACH

ROOPESH MROOPESH M S2 MBA S2 MBA

IMK KOLLAMIMK KOLLAM

INTRODUCTIONINTRODUCTION The capital structure should be examined The capital structure should be examined

from the view point of its impact on the from the view point of its impact on the value of the firm. It can be legitimately value of the firm. It can be legitimately expected that if the capital structure expected that if the capital structure decision affects the total value of the firm, decision affects the total value of the firm, a firm should select such a financing mix a firm should select such a financing mix as will maximize the shareholders wealth. as will maximize the shareholders wealth. Such a capital structure is referred to as Such a capital structure is referred to as the optimum capital structure. The the optimum capital structure. The optimum capital structure may be defined optimum capital structure may be defined as the capital structure or combination of as the capital structure or combination of debt and equity that leads to the debt and equity that leads to the maximum value of the firm. maximum value of the firm.

CAPITAL STRUCTURE CAPITAL STRUCTURE THEORIES-AssumptionsTHEORIES-Assumptions

There are only two sources of funds used There are only two sources of funds used by a firm: perpetual risk less debt and by a firm: perpetual risk less debt and ordinary shares.ordinary shares.

The dividend-payout ratio is 100. That is, The dividend-payout ratio is 100. That is, the total earnings are paid out as dividend the total earnings are paid out as dividend to the shareholders and there are no to the shareholders and there are no retained earnings.retained earnings.

The total assets are given and do not The total assets are given and do not change .change .

The total financing remains constant. The The total financing remains constant. The firm can change its degree of leverage firm can change its degree of leverage either by selling shares and use the either by selling shares and use the proceeds to retire debentures or by raising proceeds to retire debentures or by raising more debt and reduce the equity capital.more debt and reduce the equity capital.The operating profits are not expected to The operating profits are not expected to grow.grow.All investors are assumed to have the All investors are assumed to have the same subjective probability distribution of same subjective probability distribution of the future expected the future expected EBITEBIT for a given firm. for a given firm.Business risk is constant over time and is Business risk is constant over time and is assumed to be independent of its capital assumed to be independent of its capital structure and financial risk.structure and financial risk.Perpetual life of the firm. Perpetual life of the firm.

THE MAJOR CAPITAL THE MAJOR CAPITAL STRUCTURE THEORIESSTRUCTURE THEORIES

Net Income ApproachNet Income Approach

Net Operating Income ApproachNet Operating Income Approach

Modigliani-Miller (MM) ApproachModigliani-Miller (MM) Approach

Traditional ApproachTraditional Approach

NET OPERATING INCOME(NOI) NET OPERATING INCOME(NOI) APPROACHAPPROACH

This Approach is diametrically opposite to This Approach is diametrically opposite to the NI Approach .the NI Approach .

The essence of this Approach is that the The essence of this Approach is that the capital structure decision of a firm is capital structure decision of a firm is irrelevant.irrelevant.

Any change in leverage will not lead to Any change in leverage will not lead to any change in the total value of the firm any change in the total value of the firm and the market price of shares as well as and the market price of shares as well as the overall cost of capital is independent the overall cost of capital is independent of the degree of leverage.of the degree of leverage.

THE NOI APPROACH IS BASED ON THE NOI APPROACH IS BASED ON THE FOLLOWING PROPOSITIONSTHE FOLLOWING PROPOSITIONS

Overall cost of capital\Capitalization Overall cost of capital\Capitalization rate (rate (KKo)is constant.o)is constant.

The NOI Approach to valuationThe NOI Approach to valuation argues that the overall capitalization argues that the overall capitalization rate of the firm remains constant,for rate of the firm remains constant,for all degree of leverage.The value of all degree of leverage.The value of the firm ,given the level of EBIT,is the firm ,given the level of EBIT,is determined bydetermined by

V=EBIT\V=EBIT\KKoo

RESIDUAL VALUE OF EQUITYRESIDUAL VALUE OF EQUITY

The value of equity is a residual The value of equity is a residual value which is determined by value which is determined by deducting the total value of debt (B) deducting the total value of debt (B) from the total value of the firm (V). from the total value of the firm (V).

Total market value of equity capital Total market value of equity capital ((SS)=)=VV--BB

CHANGES IN COST OF EQUITYCHANGES IN COST OF EQUITY

The equity-capitalization rate \cost ofThe equity-capitalization rate \cost of equity equity capital (capital (kkee) increases with the degree of ) increases with the degree of leverage.The increase in the proportion of debt in leverage.The increase in the proportion of debt in the capital structure relative to equity shares the capital structure relative to equity shares would lead to an increase in the financial risk to would lead to an increase in the financial risk to the ordinary shareholders. To compensate for the the ordinary shareholders. To compensate for the increased risk, the shareholders would expect a increased risk, the shareholders would expect a higher rate of return on their investments.The higher rate of return on their investments.The increase in the equity capitalization rate would increase in the equity capitalization rate would increase in the debt-equity ratio.increase in the debt-equity ratio.

KKee=K=Ko o +(K+(Koo-K -K ii) (B\S)) (B\S)

COST OF DEBTCOST OF DEBT The cost of debt (The cost of debt (KKii) has two parts) has two parts (a)(a)ExplicitExplicit costcost which is represented by the rate which is represented by the rate

of interest .Irrespective of the degree of leverage, of interest .Irrespective of the degree of leverage, the firm is assumed to be able to borrow at a the firm is assumed to be able to borrow at a given rate of interest.given rate of interest.

(b)(b)ImplicitImplicit or or hidden costhidden cost. As shown in the . As shown in the assumption relating to the changes in assumption relating to the changes in kkee,increases in the degree of leverage or the ,increases in the degree of leverage or the proportion of debt to equity causes an increase in proportion of debt to equity causes an increase in the cost of Equity. This increase in the cost of Equity. This increase in KKee,being ,being attributable to the increase in debt, is the implicit attributable to the increase in debt, is the implicit part of part of KKee..

..

The real cost of debt and the real cost of The real cost of debt and the real cost of equity, according to the NOI Approach, are equity, according to the NOI Approach, are the same and equal the same and equal KKoo. .

OPTIMUM CAPITAL STRUCTUREOPTIMUM CAPITAL STRUCTURE

The total value of the firm is unaffected by The total value of the firm is unaffected by its capital structure. No matter what the its capital structure. No matter what the degree of leverage is, the total value of degree of leverage is, the total value of the firm will remain constant. The market the firm will remain constant. The market price of shares will also not change with price of shares will also not change with the change in the debt-equity ratio. There the change in the debt-equity ratio. There is nothing such as an optimum capital is nothing such as an optimum capital structure. Any capital structure is structure. Any capital structure is optimum, according to the optimum, according to the NOINOI Approach. Approach.