NET OPERATING INCOME THEORY OF CAPITAL STRUCTURE

·         NET OPERATING INCOME THEORY OF CAPITAL STRUCTURE UPDATED
FINANCIAL MANAGEMENT

·         NET OPERATING INCOME

1. IT IS ALSO SUGGESTED BY DURAND.
2. THIS APPROACH IS DIAMETRICALLY OPPOSITE TO THE NI APPROACH.
3. THE ESSENCE OF THE APPROACH IS THAT CAPITAL STRUCTURE DECISIONS ARE IRRELEVANT. ANY CHANGE IN THE CAPITAL STRUCTURE DOES NOT AFFECT THE MARKET VALUE OF THE FIRM AND THE OVERALL COST OF CAPITAL REMAINS THE SAME.
4. THE OVER ALL COST OF CAPITAL REMAINS CONSTANT WHETHER DEBT-EQUITY  20 :80,80:20
5. THE MARKET CAPITALIZES THE VALUE OF THE FIRM AS A WHOLE AND THEREFORE THE SPLIT BETWEEN DEBT AND EQUITY IS IRRELEVANT.
6. THE USE OF DEBT HAVING LOW COST INCREASES THE RISK OF EQUITY SHAREHOLDERS,THIS RESULT INCREASE IN THE EQUITY CAPITALIZATION RATE.
7. THE VALUE OF EQUITY IS RESIDUAL AND IT IS CALCULATED BY DEDUCTING THE VALUE OF THE OF DEBT FROM THE TOTAL VALUE OF THE FIRM
8. ACCORDING TO MARKET PRICE PER SHARE REMAINS UNAFFECTED ON ACCOUNT OF CHANGE IN DEBT EQUITY MIX

·         ASSUMPTIONS

1. THE MARKET CAPITALIZES THE VALUE OF THE FIRM AS A WHOLE
2. BUSINESS RISK REMAINS CONSTANT
3. NO CORPORATE TAXES
4. TOTAL MARKET VALUE OF EQUITY=V-D=S

·         DIAGRAM

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·         EXPLANATION

·         COST OF DEBT AND OVER ALL COST OF CAPITAL ARE CONSTANT FOR ALL LEVEL OF LEVERAGE. AS THE DEBT PROPORTION OR THE FINANCIAL LEVERAGE INCREASES,THE RISK OF THE SHAREHOLDERS ALSO INCREASES AND COST OF EQUITY. IN CASE OF ALL EQUITY FIRM COST OF EQUITY IS EQUAL TO OVER ALL COST OF CAPITAL. AS THE PROPORTION OF THE DEBT IS INCREASED,COST OF EQUITY ALSO INCREASES.

·         OVER ALL COST OF CAPITAL REMAINS CONSTANT BECAUSE INCREASE IN COST OF EQUITY IS SET OFF TO THE BENEFITS OF DEBT FINANCING.

·         VALUE OF THE FIRM

1.     V =EBIT/K

2.     V = VALUE OF THE FIRM

3.     EBIT = EARNING BEFORE INTEREST AND TAXES

4.     K= OVERALL COST OF CAPITAL

5.     MARKET VALUE OF EQUITY= V-D=S

6.     D =MARKET VALUE OF DEBT

7.     COST OF EQUITY =(EBIT –I)/(V-D)

·         EXAMPLE

·         A COMPANY HAS NET INCOME OF 80,000. IT HAS RS 2,00,000,8% DEBENTURES. OVERALL CAPITALIZATION RATE IS 10%. CALCULATE THE VALUE OF THE FIRM AND COST OF EQUITY.. ( NO TAX EXIST)

·         ALSO COMPUTE THE VALUE OF THE FIRM AND COST OF EQUITY WHEN DEBT IS RAISED TO 3,00,000 DEBENTURES.

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·         SOLUTION

·         SOLUTION