Q. Graphic Presentation of Net Operating Income Approach ?

Graphic Presentation of NOI (Net Operating Income) Approach: - NOI (Net Operating Income) approach is explained graphically as follows:

K_e = Cost of Equity

K_d = Cost of debt

K_o = Overall cost of capital

In the given figure the degree of leverage is plotted beside the X-axis while the percentage rate of cost of capital is shown on Y-axis. The figure shows that K_d as well as K_o remain unchanged. Since the degree of leverage is increased. However with the increase in the leverage the cost of equity increases in such a manner so as to offset the advantage of using cheaper debt. Consequently K_o and the value of firm (V) remain unchanged by the increase in the financial leverage.

Basic Terms:-

EBIT = Earnings before Interest and Tax                              S = Value of Equity

B = Value of Debt                                                                  V = Value of firm

NI = Net Income                                                                    K_d = Cost of Debt

K_o = Overall Cost of Capital                                                  K_e = Cost of Equity

Basic Formulas:-

V = S + B                                            NI = EBIT - Interest

V = EBIT / K_o                    K_e= EBIT -I / S X 100                   K_o =  EBIT/ V X 100