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Net Income Approach

Net Income Approach – Capital Structure Theories | Corporate Finance

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Net Income Approach | NI Approach |  Capital Structure Theories | Corporate Finance

Net Income Approach

Net Income approach of capital structure theory assumes that the only capital can affect the value of firm and overall cost of capital. According to Net income theory, proposed by David Durand in 1952, Capital structure is relevant to the value and overall cost of capital. If firm uses debt as leverage weighted average cost of capital will decline and value of firm will be increase.

It is because cost of equity is higher than cost of debt and as the debt ratio increase overall cost of capital decline that leads to increase the value of firm.

Assumptions of Net Income Approach

1. Cost of equity is higher than cost of debt.(Ks>Kd)

2. Ks and Kd both remains constant. That means Change in capital structure does affect the financial risk of shareholder)

Net Income Approach

Example

Let us suppose there are two firms having same financial risk and same level of profit but having different capital structure;

Details Firm ABC Firm XYZ
EBIT ( Operating Income) 2,00,000 2,00,000
Debt 5,00,000 0
Cost of Equity(Ks) 10% 10%
Cost of Debt (Kd) 6% 6%

Required :

  1. Market value of equity of each firm. 
  2. Market value of total value of each firm.
  3. WACC for both firms.
  4. Suppose ABC firm issued additional debt of Rs. 2, 00,000 and used the proceeds to repurchase the common stock. Recalculate the above values assuming Ks and Kd remain constant.

 

Solution;

a. Calculation of market value of equity(S) = NI / Ks = (EBIT- interest ) / Ks

  • ABC firm (S) = (2,00,000 -5,00,000*0.06)/ 0.1  = Rs. 17, 00,000
  • XYZ firm(S) = 200000 /0.1 = Rs. 20, 00,000

 

b. Calculation of Market value of total firm (V) = D + S

  • ABC firm (V) = 17, 00,000+ 5, 00,000 =Rs. 22, 00,000
  • XYZ firm (V) = 20, 00,000 + 0 = Rs. 20, 00,000

 

c. Calculation of WACC for both firms

We have, WACC = Wd*Kd+ Ws*Ks or EBIT/ V 

  • ABC firm WACC = 200000/ 2200000   = 0.0909 = 9.09%
  • XYZ firm WACC = 200000/2000000  = 0.1 = 10%

 

Calculation of total value of firm and WACC for the firm ABC if additional debt is issued Rs. 2, 00,000.

Now,

d. Total value of Debt = 5, 00,000 + 2, 00,000 = Rs. 7, 00,000

  • Market value of equity (S) = NI / Ks = (EBIT- interest ) / Ks

                                    = [200000- (700000*0.06)]/ 0.10 

                                    = Rs. 15, 80,000

  • Value of firm (V) = S+D = Rs. 15, 80,000 + Rs. 7, 00,000 = 22, 80,000
  • WACC = EBIT /V  = 200000/ 2280000  = 0.0877 or 8.77%

 

As above mentioned illustration, When leverage is used value of firm will be increased and in other hand when leverage ratio is increased total value of firm also increased. Hence, Capital structure matters in valuation of firm and cost of capital.

Smirti
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