Management Notes

# Management Notes

Reference Notes for Management

# Net Operating Income Approach – Irrelevant Theory | Capital Structure Theories

## Net Operating Income Approach

Net Operating Income theory is called irrelevant theory since it assumes that the only capital structure change cannot affect the cost of capital and value of the firm. According to this theory irrespective of capital structure overall cost of capital will be constant, so total value of firm also remains unaffected when capital structure is changed.

As the leverage ratio is increased firm becomes more risker and leads to linear increment of cost of equity but overall cost of capital remains constant.

### Assumptions of Net Operating Income Approach

i. Cost of debt assumed to be constant.
ii. Change in the proportion of leverage affects the required rate of return as financial risk changes. Required rate of return changes linearly with change in leverage.
iii. An Increase in use of supposedly “Cheaper” the debt funds is offsets exactly by the increase in required rate of return on equity (Ke). So WACC remains same for all degree of leverage.

### Numerical Illustration

Assume that ABC Company has earnings before interest and tax amount of Rs. 2, 00,000 and following details.

 Debt Ratio Equity ratio Cost of Equity (Ks) Cost of Debt (Kd) WACC 0.00 1.00 10% 6% 10% 0.25 0.90 ? 6% 10% 0.50 0.80 ? 6% 10%

Calculate the cost of equity for given level of leverage.

Solution;

• Value of firm (V) = EBIT /WACC(Ko) = 200000 / 0.10 = Rs. 20, 00,000

Now,

a) When debt ratio 0.25

• Market value of debt = V* debt ratio = Rs. 20, 00,000 *0.25 = Rs. 5, 00,000
• Market Value of equity (S) = V- D = Rs. 20, 00,000 – 5, 00,000 = Rs 15,00,000
• Cost of equity (Ke) = (EBIT- Interest ) / Market value of equity (S) = [200000- (500000*0.06)] / 1500000 = 0.1133 or 11.33%

b) When debt ratio is 0.50

• Market value of debt (D) = V* debt ratio = Rs 20,00,000*0.50 = Rs 10,00,000
• Market Value of equity (S) = V- D = Rs 20,00,000 – Rs. 10,00,000 = Rs Rs 10,00,000
• Cost of equity( Ke) = (EBIT- Interest )/ Market value of equity (S) = [200000- (1000000*0.06) ]/ 1000000 = 0.14 or 14%

Hence, As debt ratio increase, cost of equity also increases linearly but overall cost of capital (WACC) remains same and value of firm also remains unaffected.

## FAQs

### Net operating income theory is a theory of

A. Dividend
B. Capital Structure
C. Assets
D. Bond Market

The Correct Answer for the given question is Option B. Capital Structure

On the income statement, which of the following would be classified as a period cost?