Which of the following are assumption of Net Operating Income Approach of Capital Structure?
A. There is no Corporate Tax
B. Cost of debt remain constant at all level
C. The Business risk remain constant every level of debt and equity mix
D. The cost of Debt is less than cost of equity
E. Overall cost of Capital remain constant

Choose the correct answer from the options given below:

Correct option is D

The Net Operating Income (NOI) Approach, developed by David Durand, is a capital structure theory that suggests that the value of a firm is independent of its debt-equity mix. This means that the overall cost of capital (WACC - Weighted Average Cost of Capital) remains constant, regardless of how much debt or equity the firm uses.

The key assumptions of the NOI Approach are:

1. No Corporate Taxes (A) – The model assumes that the firm operates in a tax-free environment, meaning that there are no tax benefits of using debt (such as tax shields on interest payments).

2. Cost of Debt (B) remains constant – The rate at which the firm borrows does not change, irrespective of the amount of debt used in the capital structure.

3. Business Risk remains constant (C) irrespective of the debt-equity mix – The operating risk of the firm does not change even when the proportion of debt and equity changes.

4. Overall Cost of Capital (E) remains constant – Since the value of the firm is determined by Net Operating Income and overall capital cost (WACC), the proportion of debt and equity does not affect WACC.

Information Booster:

1. NOI Approach suggests that capital structure is irrelevant:

   • The market value of a firm is determined by its net operating income (NOI)and the overall cost of capital, not the debt-equity ratio.

2. Debt does not provide a financial advantage:

   • Unlike other theories (e.g., Modigliani and Miller with tax), NOI assumes no tax benefits from debt, making capital structure decisions irrelevant.

3. WACC remains unchanged:

   • Even if a company changes its debt-equity mix, the cost of capital does not fluctuate.

4. The cost of equity increases as debt increases:

   • Investors perceive higher financial risk when a firm takes on more debt, so they demand a higher return on equity to compensate for this risk.

5. Criticism of NOI Approach:

   • The assumption of no corporate tax is unrealistic.

   • In real-world scenarios, debt financing can lead to tax savings, which contradicts the NOI theory.​

Additional Knowledge:

D. "The cost of debt is less than the cost of equity"

• While it is true that debt is generally cheaper than equity, this is not an explicit assumption of the NOI Approach.

• The NOI approach focuses on the idea that the firm’s total valuation remains unaffected by debt levels, rather than comparing debt and equity costs.