Differentiate between the following: Net Income Approach and Net Operating Income Approach.

Net income approach: According to this approach there is a relationship between capital structure and the value of the firm and therefore, the firm can affect its value by increasing or decreasing the debt proportion in the overall financial mix. The Net Income Approach makes the following assumptions: The total capital requirement of the firm is given and remains constant. Cost of debt (K d ) is less than cost of equity (K e ). Both K d and K e remain constant and any change in financial leverage (i.e., use of more and more debt financing) in the capital structure does not affect the risk perception of the investors. There are no taxes. Net operating income approach: Net operating income approach is opposite to the Net income approach. According to NOI Approach, the market value of the firm depends upon the net operating profit or EBIT and the overall cost of capital. The financing mix or the capital structure is irrelevant and does not affect the value of the firm. The NOI Approach makes the following assumptions: The investors see the firm as a whole and thus capitalize the total earnings of the firm to find the value of the firm as a whole. The overall cost of capital K o of the firm is constant and depends upon the business risk which also is assumed to be unchanged. The cost of debt, K d , is also taken as constant. The use of more and more debt in the capital structure increases the risk of the shareholders and thus results in the increase in the cost of equity capital i.e, K e . The increase in K e is such as to completely offset the benefits of employing cheaper debt, and There are no taxes.