Net Operating Income (NOI) Approach

## Net Operating Income (NOI) Approach to Capital Structure

### Core Proposition

According to the NOI approach, there is no relationship between the cost of capital and the value of the firm — i.e., the value of the firm is independent of its capital structure.

```

Value of Firm = f(NOI, Ko) — independent of Debt/Equity mix

```

### Key Implications

1. The overall cost of capital (K_o) remains constant for all degrees of leverage.

2. As debt increases:

• Cost of equity (K_e) rises to offset the benefit of cheaper debt.
• The rise in K_e exactly neutralises the cost saving from using more (cheaper) debt.

3. Therefore, WACC (K_o) does not change with capital structure.

4. The value of the firm depends only on its Net Operating Income (NOI) and its business risk — not on how it is financed.

### Assumptions of NOI Approach

1. Split of total capitalisation between debt and equity is irrelevant — investors look at the firm as a whole.

2. The overall capitalisation rate (K_o) is constant for all levels of leverage. K_o depends only on business risk.

3. The cost of debt (K_d) is constant for all levels of leverage.

4. Use of more debt increases the financial risk to equity shareholders → they demand a higher rate of return (K_e rises).

5. There are no corporate taxes.

### Valuation Formula

$$

V = \frac{NOI\ (or\ EBIT)}{K_o}

$$

Value of Equity (E) = V − D (where D = market value of debt)

$$

K_e = \frac{NOI - Interest}{E}

$$

### Comparison with Other Theories