Question 3 (b)
Net income versus net operating income approaches compared
7 marks
- Time to write
- About 14 minutes
From an older CBCS paper
Question
Question 3 (b) · 7 marks- Compare and differentiate between the Net Income Approach and the Net Operating Income Approach of Capital Structure theories.
Reworded from the university paper; 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
- differentiate betweenSet the differences out in a table, basis by basis, not as two separate essays.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 NI approach and its evaluation 2½ marks 4 min
- 2 NOI approach and its evaluation 2½ marks 4 min
- 3 Comparison and overall assessment 2 marks 4 min
- Check: every ask answered, key terms underlined 1 min
Short on time? Trim steps 1–3 evenly rather than skip one: each is capped at its own marks.
Try it first. About 14 minutes for 7 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.
Net income (NI) approach
The view. A firm can lower its weighted average cost of capital and raise its value, and the market price of its shares, by using as much debt as possible. The costs of debt (kd) and equity (ke) stay constant whatever the leverage, and kd < ke, so replacing equity with cheaper debt lowers ko. Assumptions: kd < ke; no taxes; investors' perception of risk is not changed by the use of debt.
- Merits: simple; correctly recognises that debt is the cheaper source and that, within limits, it can lower the cost of capital (the basis of trading on equity).
- Criticism: its central assumption is unrealistic. As debt rises, the shareholders bear more financial risk and demand a higher return, so ke cannot stay constant; lenders too charge more at high leverage. Taken literally, the approach implies that the firm should use debt to the maximum possible extent; ko approaches kd but never reaches it, as a firm can never be 100% debt-financed.
Net operating income (NOI) approach
The view. Suggested by Durand, it is the opposite extreme: a change in capital structure does not affect the value of the firm, and the overall cost of capital stays the same whatever the debt-equity mix. The market capitalises the firm as a whole, business risk is constant, and the advantage of cheaper debt is exactly offset by the rise in the cost of equity as financial risk increases. So there is no optimal capital structure: every structure is optimal.
- Merits: it recognises that leverage raises the shareholders' risk and their required return; Modigliani and Miller support the NOI approach, but provide a behavioural justification for it.
- Criticism: the exact offset is assumed, not proved; it ignores taxes, under which the deductibility of interest makes debt valuable; it assumes kd constant at every level of debt, whereas lenders charge more as risk rises; and it ignores bankruptcy costs. In practice firms do seek a target capital structure.
Overall assessment
| Point | NI approach | NOI approach |
|---|---|---|
| Effect of debt on value | Raises it | None |
| Cost of equity | Constant | Rises with debt |
| Overall cost of capital | Falls continuously | Constant |
| Optimal structure | Maximum debt | None (every structure) |
| Realism | Ignores rising financial risk | Ignores taxes and rising kd |
Both are extreme positions. The traditional approach strikes a balance: moderate debt lowers ko up to a point, beyond which rising risk raises it, giving an optimal capital structure. This middle view, and MM with taxes, describe actual firms better than either extreme.
Where the 7 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | NI approach and its evaluation | 2.5 |
| 2 | NOI approach and its evaluation | 2.5 |
| 3 | Comparison and overall assessment | 2 |
| Total | 7 |
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