Net Income (NI) vs. Net Operating Income (NOI) Approach

The difference between net income and operating income approach of capital structure is mainly due to the role of capital structure, the cost of capital, the degree of leverage, and most importantly the assumptions it is based on.

Differences between net income (NI) and net operating income (NOI) approach

Role of Capital Structure

The net income approach suggested by David Durand brings forth the relevance of capital structure in calculating the value of a firm. The WACC (Weighted Average Cost of Capital) which is the weighted average of debt and equity will decide the value of the firm. Net income approach can be represented by the following formula.

WACC = EBIT / (Value of firm)

Value of firm = Value of equity + Value of debtWith a judicious mixture of debt and equity, a firm can arrive at an optimum capital structure at which value of the firm is the highest and the overall cost of capital is the lowest. Essentially the approach says that since debt is a cheaper source of fund, it can be used effectively to increase the value of the firm by decreasing the overall cost of capital. In essence, change in the degree of leverage will have an impact on the capital structure.

With a judicious mixture of debt and equity, a firm can arrive at an optimum capital structure at which value of the firm is the highest and the overall cost of capital is the lowest. Essentially the approach says that since debt is a cheaper source of fund, it can be used effectively to increase the value of the firm by decreasing the overall cost of capital. In essence, change in the degree of leverage will have an impact on the capital structure.

On the other hand, the operating income approach suggested by David Durand states the irrelevance of capital structure in calculating the value of the firm. The cost of capital for the firm will always be the same. No matter what the degree of leverage is, the total value of the firm will remain constant. Net operating income approach can be represented by the following formula.WACC = EBIT / (Value of firm)

WACC = EBIT / (Value of firm)The value of Equity (Residual) = Value of firm – Value of debt

The value of Equity (Residual) = Value of firm – Value of debt

Degree of Leverage and Cost of Capital

The degree of leverage means the proportion of debt. The net income approach assumes that change in the degree of leverage will alter the overall cost of capital (WACC) and hence the value of the firm. Whereas the operating income approach assumes that degree of leverage of the firm is irrelevant to the cost of capital i.e. the cost of capital is always constant.

How the cost of capital remains constant irrespective of change in the degree of leverage especially when the debt is the cheaper source of finance? If the debt is increased, the risk of bankruptcy will increase. This increased risk will make equity holders increase their required rate of return. On one hand, the higher proportion of debt decreases the overall cost of capital but it is compensated by the increase in required rate of return by equity shareholders.

Assumptions

Each of the theories has made a set of assumptions which drives the valuation.
The assumptions for the net income approach are:

The assumptions for the net operating income approach are:

  • Cost of capital is always constant
  • Value of equity is residual (Derived by subtracting value of debt from value of firm)
  • If amount of debt increases, shareholders required return expectations will increase

References:
Books:
Richard A Brealey & Stewart C Myers “Principles of Corporate Finance” (6thEdition), Tata McGraw-Hill Publishing Company Limited, New Delhi, 2001.pp.524.

Articles:
http://universalteacher.com/1/theories-of-capital-structure/

Last updated on : January 20th, 2017

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