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net income & net operating income

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himanshu thakur

on 16 October 2014

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Transcript of net income & net operating income

Capital structure is the proportion of debt and equity in which a corporate finances its business.


The capital structure of a company/firm plays a very important role in determining the value of a firm.


Capital structure is also referred to as financial leverage, which strictly means the proportion of debt or borrowed funds in the financing mix of a company.


There are various theories which propagate the 'ideal' capital mix / capital structure for a firm.
Capital Structure
Net Operating Income Approach
This theory was presented by
DAVID DURAND

It is also called irrelevance approach

It suggests that value of firm is not affected by change of debt component in the capital structure
COMPARISON
Difference between net income and operating income approach of capital structure is mainly due to :

Role of Capital Structure



Degree of Leverage and Cost of Capital:




Assumptions:
Net Income Approach
This theory was presented by
DAVID DURAND

It is also called relevance approach

It suggests that there exists a relationship between capital structure and value of the firm.




Approaches
Net Income & Net Operating Income
According to this approach ,change in financial leverage of the firm will lead to corresponding change in the weighted average cost of capital(WACC) and value of the firm.

The Net Income Approach suggests that with the increase in leverage , the WACC decreases and the value of a firm increases. On the other hand, if there is a decrease in the leverage, the WACC increases and thereby the value of the firm decreases.

ASSUMPTIONS
Increase in debt will not effect the risk perceptions of the investors.
There are no corporate taxes.
The cost of debt is less than cost of equity.
According to NI approach,value of firm can be calculated as:

V=E+D

V=total market value of firm
E=market value of equity
D=market value of debenture

E=EBIT-I/Cost of Equity

EBIT=earnings before income and tax
I=interest

D=I/Cost of debt

K=EBIT/V

K=overall cost of capital

According to NI approach,value of firm can be calculated as:

V=E+D

V=total market value of firm
E=market value of equity
D=market value of debenture

E=EBIT-I/Cost of Equity

EBIT=earnings before income and tax
I=interest

D=I/Cost of debt

K=EBIT/V

K=overall cost of capital

EXAMPLE:

q.Calculate value of company.


Earnings before Interest Tax (EBIT)=100000
Bonds (Debt part)=300000
Cost of Bonds issued (Debt)=10%
Cost of Equity=14%

ans.

EBIT=100000

Less: Interest cost (10% of 300,000)=30000

Earnings after Interest Tax (since tax is assumed to be absent)=70000

Shareholders' Earnings=70000

Market value of Equity (70,000/14%)=500000

Market value of Debt=300000

Total Market value=800000

Overall cost of capital-EBIT/(Total value of firm)=100000/800000=12.5%

Now, assume that the proportion of debt increases from 300,000 to 400,000 and everything else remains same.

(EBIT)=100,000

Less: Interest cost (10% of 300,000)=40,000

Earnings after Interest Tax (since tax is assumed to be absent)=60,000

Shareholders' Earnings=60,000

Market value of Equity (60,000/14%)=428,570 (approx)

Market value of Debt=400,000

Total Market value=828,570

Overall cost of capital-EBIT/(Total value of firm)=100,000/828,570
=12%

As observed, in case of Net Income Approach, with increase in debt proportion, the total market value of the company increases and cost of capital decreases.
According to this approach , change in debt of the firm/company or the change in leverage fails to affect the total value of the firm/company and WACC of the company.

As per this approach, the market value is dependent on the operating income and the associated business risk of the firm and both these factors are not impacted by financial leverage.

. Financial leverage can only impact the share of income earned by debt holders and equity holders but cannot impact the operating incomes of the firm.
ASSUMPTIONS
Overall cost of capital remains constant
No taxes
Cost of debt is constant
Debt are completely taken away by increase in cost of equity
q.Calculate value of company.

Earnings before Interest Tax (EBIT)=100,000
Bonds (Debt part)=300,000
Cost of Bonds issued (Debt)=10%
WACC=12.5%

ans.
(EBIT)=100,000
WACC=12.5%
Market value of the company-EBIT/WACC=100,000/12.5%
=800,000
Total Debt=300,000
Total Equity-Total market value-total debt
=800,000-300,000=500,000
Shareholders' earnings-EBIT-interest on debt
=100,000-10% of 300,000=70,000
Cost of equity=70,000/500,000
=14%




EXAMPLE:
According to this approach,value of a firm can be calculated:

V=EBIT/K
V=market value of firm
EBIT=earnings before interest and taxes
K=overall cost of capital

E=V-D
E=market value of equity
D=market value of debentures

Cost of equity=NI/E
NI=net income

Now, assume that the proportion of debt increases from 300,000 to 400,000 and everything else remains same.

(EBIT)=100,000

WACC=12.5%

Market value of the company-EBIT/WACC=100,000/12.5%
=800,000

Total Debt=400,000

Total Equity-Total market value-total debt=800,000-400,000
=400,000

Shareholders' earnings-EBIT-interest on debt=100,000-10% of 400,000
=60,000

Cost of equity=60,000/400,000=15%

As observed, in case of Net Operating Income approach, with the increase in debt proportion, the total market value of the company remains unchanged, but the cost of equity increases.

According to this approach,value of a firm can be calculated:

V=EBIT/K
V=market value of firm
EBIT=earnings before interest and taxes
K=overall cost of capital

E=V-D
E=market value of equity
D=market value of debentures

Cost of equity=NI/E
NI=net income

The net income approach suggested THE relevance of capital structure in calculating the value of firm. The WACC (Weighted Average Cost of Capital) which is the weighted average of debt and equity will decide the value of the firm



The operating income approach suggested by David Durand states the irrelevance of capital structure in calculating the value of the firm. The cost of capital for the firm will always be the same. No matter what the degree of leverage is, the total value of the firm will remain constant

The net income approach assumes that change in degree of leverage will alter the overall cost of capital (WACC) and hence the value of the firm




The operating income approach assumes that degree of leverage of the firm is irrelevant to the cost of capital i.e. the cost of capital is always constant.

The assumptions for the net income approach are:

No taxes
Cost of debt is less than cost of equity
Debt doesn’t change perception amongst investors


The assumptions for the net operating income approach are:

Cost of capital is always constant
Value of equity is residual (Derived by subtracting value of debt from value of firm)
If amount of debt increases, shareholders required return expectations will increase
HIMANSHU THAKUR-296
KARAN MEHTA-286
KIRTI BHATI-327
LAVISHA RAJAN-269
RIBEKKA SINGH-263
THANK YOU..!
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