Explain the Net operating approach to capital structure

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

•  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.

•  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.

•  The debt capitalisation rate is constant.

•  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.
The net operating income approach examines the effects of changes in capital structure in terms of net operating income. In the net income approach discussed above net income available to shareholders is obtained by deducting interest on debentures form net operating income. Then overall value of the firm is calculated through capitalization rate of equities obtained on the basis of net operating income, it is called net income approach. In the second approach, on the other hand overall value of the firm is assessed on the basis of net operating income not on the basis of net income. Hence this second approach is known as net operating income approach.

The NOI approach implies that whatever may be the change in capital structure the overall value of the firm is not affected. Thus the overall value of the firm is independent of the degree of leverage in capital structure. Similarly, the overall cost of capital is not affected by any change in the degree of leverage in capital structure. The overall cost of capital is independent of leverage. If the cost of debt is less than that of equity capital the overall cost of capital must decrease with the increase in debts whereas it is assumed under this method that overall cost of capital is unaffected and hence it remains constant irrespective of the change in the ratio of debts to equity capital. How can this assumption be justified? The advocates of this method are of the opinion that the degree of risk of business increases with the increase in the amount of debts. Consequently the rate of equity over investment in equity shares thus on the one hand cost of capital decreases with the increase in the volume of debts; on the other hand cost of equity capital increases to the same extent. Hence the benefit of leverage is wiped out and overall cost of capital remains at the same level as before. Let us illustrate this point. If follows that with the increase in debts rate of equity capitalization also increases and consequently the overall cost of capital remains constant; it does not decline.
To put the same in other words there are two parts of the cost of capital. One is the explicit cost which is expressed in terms of interest charges on debentures. The other is implicit cost which refers to the increase in the rate of equity capitalization resulting from the increase in risk of business due to higher level of debts.