Page 134 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes
NI
Market value of equity (S) =
Ke
Where,
NI = Earnings available for equity shareholders,
Ke = Equity capitalization rate.

Under NI approach, the value of the firm will be maximum at a point where average cost of
capital is minimum. Thus the theory suggests total or maximum possible debt financing for
minimizing the cost of capital.
E.B.I.T.
The overall cost of capital =  100
Value of thefirm

The NI approach can be illustrated with the help of the following example.

Example: Expected EBIT of the firm is 2,00,000. The cost of equity (i.e., capitalization
rate) is 10%. Find out the value of Firm and overall cost of capital if degree of leverage is:
200000

500000
700000
Debenture interest rate is 6%.
Statement Showing the Value of Firm and Overall Cost of Capital WACC

Conclusion: Firm is able to increase its value and to decrease it’s (WACC) increasing the debt
proportion in the capital structure.
The NI approach, though easy to understand, ignores perhaps the most important aspects of
leverage that the market price depends upon the risk, which varies in direct relation to the
changing proportion of debt in capital structure.

7.4.2 Net Operating Income (NOI) Approach
The Net Operating Income (NOI) approach is the opposite of the NI approach. According to the
NOI approach, the market value of the firm depends upon the net operating profit or EBIT and

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