Explain Net operating income theory of capital structure.

Capital structure of a company depends on mix or ratio of debt and equity in their mode of their financing. Depending on what company prefer, some may have more debt or more equity in financing their asset, but final goal is to maximize their market value and their profits.

Net operating income (NOI) was developed by David Durand. According to net operating income approach, firm value is not affected by change in company or firm’s debt components.

Net operating income approach says that value of a firm depends on operating income and associated business risk. Value of firm will not be affected by change in debt components.

Assumptions are as follows −

• Debt and equity are source of financing.

• Dividend pay-out ratio is 1.

• No taxes.

• No retained earnings.

• Constant debt capitalisation.

• Constant WACC.

• Difference between firm value and value of debt is value of equity.

• Cost of equity is larger than cost of debt.

Formulas

Market value of a firm (V) is ratio of earnings before income taxes (EBIT) and weighted average cost of capital (WACC).

V = EBIT/WACC

Total equity (E) is difference of market value of a firm (V) and market value of Debt (D).

E = V – D

Cost of equity (Ke) is ratio of difference between Earnings per share (EBIT) and interest (I) to market value of equity shareholder’s (Es).

Ke= (EBIT-I)/Es

Disadvantages of NOI are as follows −

• No corporate tax.

• If cost of debt increases, then financial leverage also increases which also, increases the capital cost.

• Investors will have different view of firm’s having high debt in their capital structure.