NET OPERATING INCOME (NOI) APPROACH
This theory was also developed by David Durand (Pandey 2005). He probably realized the
shortcomings of NI Approach and therefore, he modified the NI approach to NOI approach.
As per this approach, the market value of the firm is based on the earning available for fund
providers after paying all other expenses except interest on debt. The profit available for funds
providers or for calculating the market value of the firm is called Net operating Income (NOI).
This theory is just opposite to NI approach. NI approach is relevant to capital structure decision.
It means decision of debt equity mix does affect the WACC and value of the firm. As per NOI
approach the capital structure decision is irrelevant and the degree of financial leverage does not
affect the WACC and market value of the firm. NOI approach evaluates the cost of capital and
therefore the optimal Capital Structure on the basis of operating leverage by means of NOI
approach.
The NOI approach is based on following assumptions:
(i) There are no corporate taxes.
(ii) Cost of debt remains constant at all level of debt.
(iii) Overall cost of capital remains constant.
(iv) Value of the firm depends on expected net operating income and overall capitalization rate
or the
opportunity cost of capital.
(v) Net operating income of the firm is not affected by the degree of financial leverage.
(vi) The operating risk or business risk does not change with the change in debt-equity mix.
(vii) WACC does not change with the change in financial leverage.
The NOI approach is based on two prepositions.
Preposition I
As per NOI approach, the value of firm depends on the earning and business risk rather than the
financial risk to finance the assets arising out of financial leverage. As per this proposition the
market value of the firm is calculated by capitalizing the net operating income and not the Net
Income, hence it is called as NOI approach.
Under NOI approach the market value of the firm is calculated by dividing the Net Operating
Income by the overall cost of capital i.e. by capitalizing the NOI.
Therefore, Market value of the firm (V) = Net Operating Income (NOI) / Market value of the
firm (V)
Under the core preposition of NOI approach, the overall cost of capital depends on the business
risk of the firm, and business risk does not change with change in debt equity mix, hence overall
cost of capital remains constant.
Preposition II
As per NOI approach, even if the firm uses more and more debt in the capital structure, the
overall cost does not change even though the debt is cheaper than equity. This is because the
equity share holders increase their expectations of return on their investment with every increase
in debt resulting in increased business risk. Consequently, the benefit of cheaper debt is offset by
higher expected rate of return on equity and therefore overall cost of capital remains constant.
This phenomenon is also shown in following diagram:
Ke
Cost of Capital
Ko
Kd
Financial Leverage
Effect of Financial leverage on Cost of Equity, Cost of Debt and Over all Cost of Capital
under NOI approach
It is clear from the diagram that with increase to financial leverage, the overall cost of capital
(Ko) and cost of debt (Kd) remains at the same level but cost of equity increases with increase in
financial leverage. This is because the expected rate of return on equity increases with the
increase in financial risk in the business. Overall cost of capital remains constant because the
benefit of low cost of debt is neutralized by increase in the cost of equity.
Optimum capital structure under NOI Approach:
As per NOI approach the cost of debt, market value of the firm and the market value of the
equity shares remain constant irrespective of change in the financial leverage and the benefit of
low cost of debt is offset by the increased rate of return on equity with the increase in debt in the
capital structure. Therefore, the overall all cost of capital remains the same at any level of debt;
hence, the capital structure is optimum at any level of debt-equity mix. Under the circumstances,
the optimum level of capital structure composed on debt-equity composition becomes
indeterminate, as the impact of financial leverage is counter balanced by a corresponding change
in Ke in the opposite direction.
Criticisms of NOI approach
The NOI approach is criticized on the following grounds:
(i) The assumption of absence of corporate tax is not correct.
(ii) The cost of debt increases with the increase in the quantum of debt.
(iii) As the cost of debt increases with the increase in financial leverage, the overall cost of
capital also
increases with increase in financial leverage.
(iv) An investor values differently the firm having higher level of debt in its capital structure than
the firm
having less debt or no debt.
