Net operating income vs net operating income capital structure

Finance

1. Net Income Vs Net Operating Income Capital structure Model Tejas

2. Importance of Capital structure theories Capital Structure refers to the combination or mix of debt and equity which a company uses to finance its operations. Raising of capital from different sources and their use in different assets by a company is made on the basis of certain principles that provide a system of capital so that the maximum rate of return can be earned at a minimum cost that principles is known as capital structure Capital structure theories represents the relationships between the capital structure, cost of capital and value of firm These theories are based on certain assumptions Capital structure theories shows whether any change in the financing mix would have an impact on the value of firm or not

3. Capital structure theories Net income theory According to this theory a firm can increase the value of the firm and reduce the overall cost of capital by increasing the proportion of debt in its capital structure to the maximum possible extent. Net Operating Income Theory According to this theory, the total market value of the firm (V) is not affected by the change in the capital structure and the overall cost of capital (Ko) remains fixed irrespective of the debt-equity mix. Traditional Theory According to this theory, a firm can reduce the overall cost of capital or increase the total value of the firm by increasing the debt proportion in its capital structure to a certain limit. Because debt is a cheap source of raising funds as compared to equity capital. Modigliani-Miller Theory No Tax -Capital structure is irrelevant to the value of a firm. Value would not affect by the choice of finance adopted to finance the assets. The value of a firm is dependent on the expected future earnings. TAX -Financial leverage boosts the value of a firm and reduces WACC .

4. Assumptions There are only two source of financing - Debt and Equity The firm has decided to distribute all its earnings as dividend rather than keeping as retained earnings (100% dividend payout) The operating profit of firm is given and is not expected to grow or decline over time Business risk will remain constant irrespective of financial composition There is no income tax or corporate tax No transaction cost   No change in investment decision or assets

5. Net income theory This theory was propounded by “David Durand” A change in financial leverage would lead to a change in the cost of capital. Cost of raising fund through debt is lower as compared to equity capital ( Kd < Ke ) If the Ratio of debt in the capital structure increases, the weighted average cost of capital decreases and hence the value of the firm increases.

6. Numerical Proof Q.EBIT= 5,00,000 Debt = 3,00,000 Cost of Debt = 5% Cost of Equity = 10% SOL: Shareholder earnings =EBIT- Interest (5%of 3,00,000)=4,85,000 Market value of equity = Shareholder's Earnings / Cost of equity 4,85,000/0.10 = 48,50,000 Market value of debt = 3,00,000 Total Market Value of firm = Market value of equity + Market value of debt = 51,50,000 Overall Cost of Capital = EBIT / Total value of Firm= 5,00,000/51,50,000 = 0.097*100 = 9.70% Q.EBIT= 5,00,000 Debt = 4,00,000 Cost of Debt = 5% Cost of Equity = 10% SOL: Shareholder earnings =EBIT- Interest (5%of 4,00,000)=4,80,000 Market value of equity = Shareholder's Earnings / Cost of equity 4,80,000/0.10 = 48,00,000 Market value of debt = 4,00,000 Total Market Value of firm = Market value of equity + Market value of debt = 52,00,000 Overall Cost of Capital = EBIT / Total value of Firm= 5,00,000/52,00,000 = 0.0961*100 = 9.61%

7. Weighted average cost of capital Verify case 1 WACC= + ) =(5* +10* ) =0.291+9417= 9.70 % Debt=3,00,000 Equity=48,50,000 WACC=9.70% Market value=51,50,000   Verify case 2 WACC= + ) =(5* +10* ) =0.384+9.230= 9.61 % Debt=4,00,000 Equity=48,00,000 WACC=9.61% Market value=52,00,000  

8. Net operating income theory This theory was propounded by “David Durand” Capital structure does not matter in determining the value of the firm Value of the firm remains the same and is not affected by change in debt Increase in debt increases risk perceived by investors Thus firm with high debt in capital structure results in high required rate of return by investors Weighted average cost of capital remains the same with increased cost of equity

9. Numerical Proof Q. Earning before Interest & Tax = 3,00,000 Debt = 5,00,000 Cost of Debt = 5% WACC = 10% Sol : Market value of firm = EBIT/WACC = 3,00,000/0.10 = 30,00,000 Total equity = Market value of firm - Total debt = 30,00,000 - 5,00,000 = 25,00,000 Shareholder's Earnings = EBIT - Interest on debt = 3,00,000 - (5% of 5,00,000) = 2,75,000 Cost of equity = Shareholder's earnings / Total equity = 2,75,000/25,00,000 = 0.11 * 100 = 11% Q . Earning before Interest & Tax = 3,00,000 Debt = 8,00,000 Cost of Debt = 5% WACC = 10% Sol : Market value of firm = EBIT/WACC = 3,00,000/0.10 = 30,00,000 Total equity = Market value of firm - Total debt = 30,00,000 - 8,00,000 = 22,00,000 Shareholder's Earnings = EBIT - Interest on debt = 3,00,000 - (5% of 8,00,000) = 2,60,000 Cost of equity = Shareholder's earnings / Total equity = 2,60,000/22,00,000 = 0.1181 * 100 = 11.81%

10. Conclusion The difference between net income and operating income approach of capital structure is mainly due to the role of capital structure, the cost of capital, the degree of leverage, and assumptions Basis Net Income Net operating income Role of Capital structure There is relevance of capital structure in value of firm  There is no relevance of capital structure in the value of the firm  Degree of leverage and cost of capital  Assumes change in the degree of leverage will alter the WACC Assumes that degree of leverage is irrelevant to the cost of capital  Assumptions No taxes Cost of debt is lesser that cost of equity  Cost of capital is always constant  Value of equity is cost of capital - Debt Increase in debt increases the expectations of shareholders  

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