Advanced Financial Management 6th Semester

Procedure of NI - Approach
This approach has been developed by Durand. It is relevant theory. According to this
approach capital structure decisions is relevant to the valuation of firm
Assumptions:
 There are no taxes

 Cost of debt is less than cost of equity

 Use of debt in capital structure does not change the risk perception of investors

 Cost of debt and Cost of equity remain same

EBIT-Interest = EBT-Tax = EAT (profits available for equity shareholders)

Ke should be given
Market value of equity profits available for equity shareholders
Add: Market value of debt

Market value of firm ( V )

Kd or Ki = Cost of Debt
Overall cost of capital ( Ko)
EBIT
Ko = x 100
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚

Problem 1 B.Com VI Semester - May 2016 (15 marks)

ABC Company is expected an EBIT (Net Operating Income) of Rs.100000 whose
equity capitalization rate is (K) is 12.5%. Currently company has a debt capital
of Rs.400000 at 8%.
Calculate as per net income approach:

a. The total market value of the firm (V) and overall cost of capital (Ko) for the
above situation

b. The total market value of the firm (V) and overall cost of capital (Ko) when
the company Increase debt by Rs.200000

c. The total market value of the firm (V) and overall cost of capital (Ko) when
the company reduce debt to Rs.200000

Bettaswamy C S, Asst. Prof. VVFGC Page 1

Advanced Financial Management 6th Semester

Problem 2
A company expects a net operating income of Rs.80000. It has Rs.200000, 8%
Debentures. The equity capitalization rate of the company is 10%.
a. Calculate the value of the firm and overall capitalization rate according to
the net income approach (ignoring the income tax)
b. If the debentures are increased to Rs.300000, what shall be the value of the
firm and the overall capitalization rate?
c. If the debentures are reduced to Rs.100000, what shall be the value of the
firm and the overall capitalization rate?

Problem 3 B.Com VI Semester - May 2016 (5 marks)

Calculate the market value of the firm and over all Capitalizations by using net
Income approach.
Total net income Rs.100000 (EBT)
Equity capitalization rate 18%
The existing debt capital Rs.500000
Interest rate per year 6%
b. Show the impact of increasing the debt capital by Rs.300000 and retire the
debt capital by Rs.200000

Problem 4:

A firm expects an operating income of 15% on its total assets Rs.2000000. An

equity Ke capitalization rate of the firm is 12%. The firm is all equity firms.
Calculate the market value of the firm and cost of capital under NI approach.

Problem 5:
Joy Ltd., expects to go a NI (Net income) of Rs.500000. The company has
Rs.1000000, 10% Debentures. The cost of equity is 12%(Ke). Calculate the
value of the company and its overall cost of capital under NI Approach?

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Advanced Financial Management 6th Semester

Problem 6 B.Com VI Semester- May 2012 and 2015 (5 marks)

A company expects a net income of Rs.90000. It has Rs.300000, 10%
debentures, the equity capitalization rate of the company 12%.
Calculate the value of the firm and over all capitalization rate according to the
net income approach (ignoring income tax)

Problem 7:
Yashas Ltd., has at present an EBIT of Rs.150000 and the company has 10%
debt ofRs.500000 in its capital structure. The equity capitalization rate is 12%.
Find out market value of the company and overall cost of capital under NI
approach.
Also find market value of the company and overall cost of capital when the
company decides toretire Rs.300000 worth of debentures by the issue of new
equity shares to the same extent ofdebt amount

Bettaswamy C S, Asst. Prof. VVFGC Page 3

Advanced Financial Management 6th Semester

NET OPERATING INCOME APPROACH (NOI)

(Ko should be given)

Durand advocated another theory of capital structure stating there in that,

there is no one optimal capital structure.

Every capital structure is an optimal capital structure. Any combination of

debt to equity mix in the capital structure does not affect the value of the firm
and the overall cost of capital remains constant irrespective of debt financing.
Hence it is just opposite to Net Income approach.

Assumptions:

 Cost of over all capital remain constant

 The market capitalizes the value of the firm as a whole
 The increase in the cost of debt financing in the capital mix off set in
increase in the return to equity shareholders
 The debt capitalization rate is constant
 The corporate income tax does not exist

Hints: WACC = Weighted Average Cost of Capital

Overall cost of Capital = Weighted average cost of capital = Ko,

Problem 1

A company has net operating income of Rs.200000; average cost of capital is

10% and has the debt component of Rs.600000, 8% in the capital mix.

a. Find out the value of the firm, cost of equity and weighted average cost of
capital under Net Operating Income approach.

b. Calculate the weighted average cost of capital and market value of the equity
when debt capital is increased to Rs.1000000 (rate of interest same)

Calculate the weighted average cost of capital and market value of the equity
when debt capital is decreased to Rs.400000 (rate of interest same)

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Advanced Financial Management 6th Semester

Problem 2

Calculate the market value of the equity and weighted average of capital from
the following data:

Net operating income Rs. 200000

Overall capitalization rate 20%

Existing debt capital of the company Rs.500000 at 10%

a. Calculate market value of equity and equity capitalization rate

b. Calculate market value of equity share and equity capitalization rate, when
debt capital is increased to Rs.800000

c. Calculate market value of equity share and equity capitalization rate, when
debt capital redeemed by (retired by) Rs.200000.

Problem 3 B.Com VI Semester-Dec 2016 (5 marks)

A Company has net operating income of Rs.200000. Average cost of capital is

10% and has the debt component of Rs.600000, 8% in the capital mix. Find
out the value of the firm by Net Operating Income Approach and also calculate
cost of equity

Problem 4 B.Com VI Semester-December 2017 (15 marks)

The Robot Ltd., has an expected EBIT of Rs.100000 and the overall
capitalization rate of the company is 15%. The company has a 10% debt of
Rs.300000. You are required to compute the value of the company, market
value of equity and cost of equity under NOI approach in thefollowing cases:

a. When the debt is increased by Rs.100000

b. When the debt is decreased to Rs.200000

Bettaswamy C S, Asst. Prof. VVFGC Page 5

Advanced Financial Management 6th Semester

BOTH THE METHODS - WITHOUT TAX

Problem 1 B.Com VI Semester- May 2013

A Company has EBIT of Rs.60000. It has in its capital structure 10%

Debentures of Rs.150000.

Its current equity capitalization rate is 15% (Ke). What is the value of company
under?

a. Net Income Approach

b. Net Operating Income Approach

Problem 2: Calculate the market value of firm under NI and NOI approach:

Net operating Income Rs.200000

Equity capitalization rate 18%

Existing debt capital Rs.1000000

Interest rate 6% p.a.

Overall capitalization rate 13%

Show the impact of the increase in debt up to Rs.1200000 and reducing it to

Rs.800000

BOTH THE METHODS - WITH TAX RATE

a. Under Ni approach = same procedure

b. Under NOI approach:

EBIT (1−Tax rate)

Value of Unlevered firm = V𝑢 = Ke

Value of levered firm = VL = Vu+ [Debt amount x tax-rate]

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Advanced Financial Management 6th Semester

Problem 1 B.Com VI Semester- (15 marks) NI & NOI Approach

There are two companies A Ltd. And 8 Ltd. Both have earnings of 25% on their
total assets. Both the companies have total assets of Rs. 2000000 each. A Ltd.
Has debt capital of Rs.1000000 borrowed at the rate of 12% while B Ltd. Has
no debt capital.

Both the companies are subject to tax rate of 50% and have equity
capitalization rate of 15%.

Calculate the value of both the companies using NI and NOI approach.

Problem 2 B.Com VI Semester - (15 marks)

Two companies X Ltd and Y Ltd. Are in the same risk class and are identical in
every aspect except that X Ltd uses debt, while Y Ltd Does not) The levered
company has Rs.450000 debentures carrying 10% rate of interest.

Both the companies earn 20% operating profit on their total assets of
Rs.750000. Assume perfect capital markets, rational investors and so on. tax
rate of 35% and capitalization rate 15% for an all equity company.

You are required to compute the value of both the companies using:

a. Net income approach

b. Net operating income approach

Bettaswamy C S, Asst. Prof. VVFGC Page 7

Advanced Financial Management 6th Semester

Problem 3

Companies X and Y are identical in all respects including risk factor except for
debt-equity. X having issued 10% debentures of Rs.18 lakhs while Y has issued
only equity. Both the companies earn 20% before interest and taxes on their
total assets of Rs.3000000. Assume tax rate of 30%, capitalization rate of 15%
for an all equity company.

Compute the value of the companies under.

a. NI approach

b. NOI approach

Problem 4 B.Com V Semester-November 2007 (5 marks)

A Company has EBIT of Rs.60000. It has in its capital structure 10%

Debentures of Rs.150000. Its current equity capitalization rate is 16%. What
would be its overall cost of capital and total value of the company under
traditional approach of capital structure theory?

MODIGLIANI-MILLER APPROACH (MM HYPOTHESIS)

 This approach was developed by Professors, Franco Modigliani and

Mertan Miller [MM, hereafter) in their classic contribution on capital
structure, which has been called the most influential finance article ever
written, who later became Nobel Laureates in economics, MM Approach
is identical to the NOI approach.

 In other words, the total value of the firm is independent of its capital
structure. However, there is a basic difference between NOI and MM
approach.

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Advanced Financial Management 6th Semester

 The NOI approach is purely definitional, which does not provide

operational justification for irrelevance of the capital structure in the
valuation of the firm.

 MM argues that, in the absence of taxes, firm's total market value and
overall cost of capital remains constant to the change of debt capital
proportion in capital structure. This has been proved by operational
justification.

Assumptions

• MM approach is based on the following assumptions:

• (a) Information is available free of cost

• (b) The same information is available for all investors

• (c) Securities are infinitely divisible

• (d) Investors are free to buy or sell securities

• (e) There is no transaction cost

• (f) There are no bankruptcy costs

• (g) Investors can borrow without restriction on the same terms on which
a firm can borrow

• (h) Dividend payout ratio is 100 per cent

• (i) EBIT is not affected by the use of debt

Bettaswamy C S, Asst. Prof. VVFGC Page 9

Advanced Financial Management 6th Semester

TRADITIONAL APPROACH

 This traditional approach was given by Soloman. In the preceding

approaches of capital structure we have discussed that the Net Income
(NI) approach and Net Operating Income (NOI) approach represents two
extreme views with regard to the relation between leverage (use of debt)
and value of the firm (cost of capital).

 According to the NI approach, use of debt in capital structure affects

both cost of capital (K) and total value of the firm, on the other hand, NOI
approach suggests that the use of debt in capital structure is irrelevant
to the value of the firm and cost of capital. Another approach given by
MM supports the NOI approach, but validity of MM approach is doubtful
due to the imperfect assumptions.

 Traditional approach is the mid-way between the NI and NOI approaches.

It is a compromise the between the two approaches. It is also known as
"Intermediate Approach". Traditional approach apartly takes some
features of NI approach and NOI approach.

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