Question 4
Net income versus net operating income approaches; leverages
18.75 marks
- Time to write
- About 38 minutes
From an older CBCS paper
Question
Question 4 · 18.75 marksQ4. Using a numerical example, explain and compare the approaches of 'Net Income' and 'Net Operating Income' to capital structure and to firm valuation.
From the information below, calculate the Operating Leverage, the Financial Leverage and the Combined Leverage:
| Particulars | Amount (Rs.) |
|---|---|
| Sales | 10,80,000 |
| EBIT | 2,88,000 |
| EBT | 1,50,000 |
| Tax Rate | 35% |
| Variable Cost | 60% of sales |
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- compareCompare in a table, basis by basis.
- exampleExamples are asked for: one short example with each point.
- calculateFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
No mark is printed for the question; the paper asks for any four of six, equal marks.
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 NI and NOI approaches explained 5 marks 9 min
- 2 Numerical example 4 marks 7 min
- 3 Comparison 3 marks 6 min
- 4 Operating, financial and combined leverage 6.8 marks 12 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Try it first. About 38 minutes for 18.75 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
The NI and NOI approaches compared
Net income (NI) approach. The cost of debt (kd) and the cost of equity (ke) stay constant whatever the leverage, and kd is below ke. So as cheaper debt replaces equity, the overall cost of capital (ko) falls and the value of the firm rises: the firm can increase its value by using as much debt as possible. Assumptions: kd < ke, no taxes, and investors' risk perception unchanged by debt.
1The baker signs for the bank's money at a fixed interest.
Financial leverageThe use of fixed-charge funds (debt, preference shares) in the capital structure.
2The ovens run full, the queue is long—the loan earns more than it costs, and the owner's share swells.
FavourableThe fixed-charge funds earn more than they cost, so EPS rises.
3The same counter empty: the interest envelope still goes out, from a thinner cash box.
UnfavourableWhen ROI is below the cost of debt: EPS falls.
Net operating income (NOI) approach. The market capitalises the firm's operating income at a constant overall rate ko, so the value of the firm is independent of its capital structure. Equity is the residual (V − D), and ke rises with leverage just enough to offset the cheaper debt; capital structure decisions are irrelevant.
Numerical example (figures supplied by the answer). EBIT ₹2,00,000; debt at 10% of either ₹5,00,000 or ₹8,00,000; under NI ke = 16%, under NOI ko = 12.5%.
| Particulars (₹) | NI, debt 5,00,000 | NI, debt 8,00,000 | NOI, debt 5,00,000 | NOI, debt 8,00,000 |
|---|---|---|---|---|
| EBIT | 2,00,000 | 2,00,000 | 2,00,000 | 2,00,000 |
| Less: interest @ 10% | 50,000 | 80,000 | 50,000 | 80,000 |
| Earnings for equity | 1,50,000 | 1,20,000 | 1,50,000 | 1,20,000 |
| Value of equity (S) | 9,37,500 | 7,50,000 | 11,00,000 | 8,00,000 |
| Value of debt (D) | 5,00,000 | 8,00,000 | 5,00,000 | 8,00,000 |
| Value of the firm (V) | 14,37,500 | 15,50,000 | 16,00,000 | 16,00,000 |
| Cost of equity (ke) | 16.00% | 16.00% | 13.64% | 15.00% |
| Overall cost of capital (ko = EBIT ÷ V) | 13.91% | 12.90% | 12.50% | 12.50% |
(Under NI, S = earnings ÷ 16% and V = S + D; under NOI, V = EBIT ÷ 12.5% and S = V − D.)
| Point | NI approach | NOI approach |
|---|---|---|
| Relevance of capital structure | Relevant | Irrelevant |
| Cost of equity | Constant | Rises with leverage |
| Overall cost of capital | Falls as debt rises | Constant |
| Value of the firm | Rises with debt (₹14,37,500 → ₹15,50,000) | Unchanged (₹16,00,000) |
| Optimum structure | Maximum debt | None: every structure is optimal |
| Method of valuation | Value equity first, add debt | Value the firm first, subtract debt |
Leverages
| Particulars | ₹ |
|---|---|
| Sales | 10,80,000 |
| Less: variable cost (60%) | 6,48,000 |
| Contribution | 4,32,000 |
| EBIT | 2,88,000 |
| EBT | 1,50,000 |
Using DOL = contribution ÷ EBIT, DFL = EBIT ÷ EBT and DCL = DOL × DFL:
- Operating leverage = 4,32,000 ÷ 2,88,000 = 1.50
- Financial leverage = 2,88,000 ÷ 1,50,000 = 1.92
- Combined leverage = 1.50 × 1.92 = 2.88 (= 4,32,000 ÷ 1,50,000)
A 1% change in sales changes EBIT by 1.5% and EPS by 2.88%. (The tax rate does not affect the leverages.)
Where the 18.75 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | NI and NOI approaches explained | 5 |
| 2 | Numerical example | 4 |
| 3 | Comparison | 3 |
| 4 | Operating, financial and combined leverage | 6.75 |
| Total | 18.75 |
Report a problemopens an email to admin@getkunji.com with the question IDFMP21-Q4already filled in.