NET OPERATING INCOME APROACH

According to the net operating income (NOI) approach the market value of the firm is not affected by the capital structure changes. The market value of the firm is found out by capitalizing the net operating income at the over all or the weighted average cost of capital, which is constant.

The overall capitalisation rate depends on the business risk of the firm. It is independent of financial mix. If NOI and average cost of capital are independent of financial mix, market value of firm will be a constant are independent of capital structure changes. The critical assumptions of the NOI approach are:

    1. The market capitalizes the value of the firm as a whole. Thus the split between debt and equity is not important.

    2. The market uses an overall capitalisation rate, to capitalize the net operating income. Overall cost of capital depends on the business risk. If the business risk is assumed to remain unchanged, overall cost of capital is a constant.

    3. The use of less costly debt funds increases the risk to shareholder. This causes the equity capitalisation rate to increase. Thus, the advantage of debt is offset exactly by the increase in the equity-capitalisation rate.

    4. The debt capitalisation rate is constant.

    5. The corporate income taxes do not exist.

Thus, we find that the weighted cost of capital is constant and the cost equity increase as debt is substituted for equity capital.