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304FIN AFM Unit 2 Net Operating Income Approach

The Net Operating Income (NOI) approach assumes that the weighted average cost of capital (WACC) remains unchanged regardless of a firm's capital structure. It believes the value of a firm depends only on its net operating profit (EBIT) and overall cost of capital, not the financing mix. According to the NOI approach, a firm's value is calculated as EBIT/WACC, so changing the debt-equity ratio does not impact value as the cost of debt and equity offset each other when weighted to calculate WACC. The approach assumes investors value the firm as a whole and the business risk does not change with the capital structure.

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38 views8 pages

304FIN AFM Unit 2 Net Operating Income Approach

The Net Operating Income (NOI) approach assumes that the weighted average cost of capital (WACC) remains unchanged regardless of a firm's capital structure. It believes the value of a firm depends only on its net operating profit (EBIT) and overall cost of capital, not the financing mix. According to the NOI approach, a firm's value is calculated as EBIT/WACC, so changing the debt-equity ratio does not impact value as the cost of debt and equity offset each other when weighted to calculate WACC. The approach assumes investors value the firm as a whole and the business risk does not change with the capital structure.

Uploaded by

Karan Kache
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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304 FIN: AFM

Unit 2: Net Opeating


Income Approach

Dr. Bhagyashree S Kunte

Dr. Bhagyashree Kunte 1


Unit II: Net Operating Income Approach
According to ‘Net Operating Income Approach (NOI)’, value of
the firm is independent of its capital structure. It assumes that
the weighted average cost of capital is unchanged irrespective
of the level of gearing.
The underlying assumption behind this approach is that the
increase in the employment of debt capital increases the
expected rate of return by the stockholders and the benefit of
using relatively cheaper debt funds is offset by the loss arising
out of the increase in cost of equity.

Dr. Bhagyashree Kunte 2


Unit II: Net Operating Income Approach
A change in proportion of various sources of finance cannot alter
the weighted average cost of capital and as such, the value of
firm remains unaltered for all degrees of leverage. Under this
approach, optimal capital structure does not exist as average
cost of capital remains constant for varied types of financing
mix. NOI approach is opposite to the NI approach.
According to this approach, the market value of the firm depends
upon the net operating profit or EBIT and the overall cost of
capital, weighted average cost of capital (WACC). The
financing mix or the capital structure is irrelevant and does not
affect the value of the firm.

Dr. Bhagyashree Kunte 3


Unit II: Net Operating Income Approach
Assumptions:
The NOI approach is based on certain assumptions:
(a) The investors see the firm as a whole and thus capitalise
the total earnings of the firm to find the value of the firm as
a whole.
(b) The overall cost of capital, (Ko), of the firm is constant
and depends upon the business risk which also is assumed
to be unchanged.
(c) The cost of debt, (Kd) is also constant.
(d) There is no tax.
(e) The use of more and more debt in the capital structure
increases the risk of the shareholders and thus results in
the increase in the cost of equity capital (Ke).
Dr. Bhagyashree Kunte 4
Unit II: Net Operating Income Approach
Assumptions:
The NOI approach believes that the market values of the firm
as a whole for a given risk complexion. Thus, for a given
value of EBIT, the value of the firm remains the same
irrespective of the capital composition, and instead
depends on the overall cost of the capital.
Value of Firm (V) = EBIT/Ko
Where, EBIT = Earnings before interest and tax
Ko = Overall cost of capital
Value of Equity (S) = V-B
Where, V = Value of Firm
B = Value of debt

Dr. Bhagyashree Kunte 5


Unit II: Net Operating Income Approach
Assumptions:
Thus, financing mix is irrelevant and does not affect the value
of the firm. The value remains same for all types of debt-
equity mix. Since there will be change in risk of the
shareholders due to change in debt-equity mix, therefore,
Ke will be changing linearly with change in debt
proportions.

Dr. Bhagyashree Kunte 6


Unit II: Net Operating Income Approach
 Net Operating Income Approach by Durand
Cost of
Capital
Cost of Equity

WACC

t of Debt

0
Degree of leverage

Dr. Bhagyashree Kunte 7


Unit II: Net Income Approach

End of 2: Net Operating Income Approach

Dr. Bhagyashree Kunte 8

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