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What is Net Operating Income Approach and how to use it?


Net Operating Income: It is also developed by David Durand. It is just opposite of net income approach which states that the change in capital structure will change the value of the firm. In net operating income approach states that changes in capital structure does not change in the value of the firm and the overall cost of capital.
The cost of debt i.e. financial leverage and if there is increase in the leverage then there is no change in the value of the firm and overall cost of capital. In fact due to increase in cost of debt in capital structure, it increases the risk of decreasing the shareholders wealth. So, the company have to pay more dividends to shareholders to protect the shareholders from the risk of minimising the shareholders wealth. Therefore, there is a increase in the cost of equity if financial leverage is increasing in capital structure.
According to this approach value of firm and overall cost of capital remain unchanged and only cost of equity will changed if there is any change in cost of debt.

Assumptions of Net Operating Income:
·         There is no corporate tax.
·         The overall cost of capital remains constant.
·         Increasing the cost of debt in capital structure increases the risk of shareholders.

Formula:
V = EBIT / Ko
And,
Ke = EBIT – I / V – D
Where,
V = Value of the firm
Ko = Overall cost of capital
Ke = Cost of equity
EBIT = Earnings before interest and tax
I = Interest on debenture
D = debt or debenture

Example: Find out the value of the firm and market value of equity with the help of following information:
Particulars
Amount in Rs.
Earnings before interest and tax (EBIT)
 1, 60, 000
Cost of debt 7%
4, 70,000
Weighted cost of capital or overall cost of capital
9%

Solution: V = EBIT / Ko
= (1, 60,000 / 9)*100
= Rs. 17, 77, 778
Market value of equity = Total value of the firm – Market value of debt or debenture
= 17, 77, 778 – 4, 70, 000
=Rs. 13, 07, 778

Example: Company XYZ has 6% debenture of Rs. 3, 50, 000. The operating income of Company is Rs. 85, 000. The overall cost of capital is 8%.  Find out the cost of equity and the value of the firm.

Solution:
Value of the firm = EBIT / Ko
 = (85,000 / 8)*100
= Rs. 10, 62, 500
Market value of Equity = Total value of the firm – Market value of debt or debenture
= 10, 65, 500 – 3, 50, 000
= Rs. 7, 12, 500
Cost of Equity (Ke) = EBIT – I / V – D
= 85,000 – 21, 000 / 10, 62, 500 – 3, 50, 000
= 64, 000 / 7, 12, 500
= 8.98%

Example: Find out the cost of equity if the debenture is increases to Rs. 7, 00, 000.The weighted average cost of capital is 10%. The earnings before interest and tax are Rs. 1, 95, 200 and 7.2% debenture of Rs. 2, 90,000.

Solution:
Value of the firm = EBIT / Ko
 = (1, 95,200 / 10)*100
= Rs. 19, 52, 000
Market value of Equity = Total value of the firm – Market value of debt or debenture
= 19, 52, 000 – 2, 90, 000
= Rs. 16, 62, 000
Cost of Equity (Ke) = EBIT – I / V – D
= 1, 95,200 – 20, 880 / 19, 52, 000 – 2, 90, 000
= 1, 74, 320 / 16, 62, 000
= 10.49%
Debenture increases to Rs. 7, 00, 000 then the cost of Equity:
= EBIT – I / V – D
= 1, 95,200 – 50, 400 / 19, 52, 000 – 7, 00, 000
= 1, 44, 800 / 12, 52, 000
= 11.57%
It shows that the increase in debt will increases the cost of equity not the value of the firm.

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