Net Operating Income Approach

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The Net Operating Income Approach is in complete contrast to the Net Income Approach. According to Net Operating Income Approach, the market value of the firm is not affected by its capital structure. The value of the firm and its overall cost of capital remains same irrespective of the proportion of debt (or financial leverage) in capital structure. The Net Operating Income Approach is based on the following assumptions.

1. 1. The overall cost of capital, Ko, of the firm is known and constant. It depends upon the business risk, which is assumed to be unchanged.
   2. The cost of debt, Kd, is known and constant.
   3. Using more and more debt in the capital structure, increases financial risk to equity shareholders and results in the increase in the cost of equity capital, Ke. The increase in Ke is such that it completely off sets the benefits of employing cheaper debt.
   4. There are no taxes.
   5. Firm has perpetual life
   6. Debt capital is perpetual.

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