NET INCOME APPROACH

BY : SIMI.P M

Net Income (NI) approach• This theory was propounded by David Durand and also known as Fixed ke

theory.• According to this approach the value of the firm is increase and decrease

overall cost of capital by increasing the proportion of debt financing in capital structure.

• It is due to the fact that debt is generally a cheaper source of finance because: 1) interest rate is lower than the dividend rate 2) benefit of tax because int. is deductible expense. •

Cont…

• both the cost of debt and cost of equity are independent of the capital structure; they remain constant regardies of how much debt the firm uses. As the result ,the overall cost of capital decline and the firm value increases with the debt.

• This approach has no basis in reality; the optium capital structure would be 100 % debt financing under NI approach.

Cont…• ie., cost of debt = interest market value of debt cost of equity= earnings available to shareholders , market value of shares outstanding value of the firm = market value of debt + market value of equity.• accordingly, under this approach, the firm’s overall cost of capital or

expected rate of return (WACC) is expressed as: cost of capital = net operating income value of firm.

formula

• V= S+D where, V= the total market value S= market value of equity share, net income equity capitalization rate D= market value of debt

Assumptions of NI approach• There are no taxes • The cost of debt is less than the cost of equity • The uses of debt does not change the risk perception of the investors. if the firm is using equity capital alone , the composite cost of capital will equal to cost of equity and the value of the firm will be minimum..