Net Operating Income Approach Assignment Help | Net Operating Income Approach Homework Help


The Net Operating Income (NOI) approach is opposite to the NI approach. According to the NOI approach, the market value of the firm depends upon the net operating profit or EBIT and the overall coat of capital, WACC. The financing mix or the capital structure is irrelevant and does not affect the value of the firm. The NOI approach makes the following assumptions:

1)    The investors see the firm as a whole and thus capitalizes the total earning of the firm to find
        the value of the firm as a whole.
 2)   The overall cost of capital ,WACC, k o, of the firm is constant and depends upon the  business
        risk which is assumed to be unchanged.
3)    The cost of debt, kd, is also taken as constant.
4)    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 i.e., k e.  The increase in k e  is
        such as to completely off set the benefits of employing cheaper debt.
5)    That there is no tax.

The NOI approach is based on the argument that the market values the firm as a whole for a given risk complexion. Thus, for a given value of EBIT, the value of the firm remain same irrespective of the capital composition and instead depends on the overall cost of capital. The value of the Equity may be found by deducting the value of debt from the total value of the firm i.e.,

                         V  =  EBIT / k  o

        And  E  =  V -  D
       And the cost of equity capital, k   e  , is

                        k  e  = EBIT  -  Int.  /  V- D

Thus, the 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 as a result of change in debt-equity mix, therefore, the k  e will be changing linearly with change in debt proportions. The NOI approach to the relationship the leverage and cost of capital has been presented in fig.
Fig. shows that the cost of debt ,k   d, and the overall cost of capital, k  o, are constant for all levels of leverage. As the debt proportion or the financial leverage increases, the risk of the shareholders also increases and thus the cost of equity capital, k  e, also increases. However, the increase in k   e, is such that the overall value of the firm remains same.        

For more help in Net Operating Income (NOI) Approach please click the button below to submit your assignment: