NET INCOME APPROACH

The net income approach, net operating income approach, and traditional approach are three theoretical frameworks for how a company should set its debt-equity mix. All three examine how a company's cost of capital changes with the debt-equity mix and search for the lowest value of the cost of capital, hence the maximum value of the firm, to identify the best mix. They reach different conclusions because they make different assumptions about creditors' and investors' reactions to increasing debt. Each of us will have our own feelings about the reasonableness of the assumptions. Without going into the Modigliani-Miller mathematics, the assumptions of the traditional approach usually seem most reasonable to most people. (1) The net income approach makes the simplest assumptions, that neither creditors nor investors increase their required rates of return as a company takes on debt. The cost of capital declines as higher-cost equity is replaced with lower-cost debt. This approach concludes that the optimal financing mix is all debt. (2) The net operating income approach assumes that creditors do not increase their required rate of return as a company takes on debt, but investors do. Further, the rate at which investors increase their required rate of return as the financing mix is shifted toward debt exactly offsets the weighting away from the more expensive equity and toward the cheaper debt. The result is that the cost of capital remains constant regardless of the financing mix. This approach concludes that there is no optimal financing mix-any mix is as good as any other. (3) The traditional approach assumes that both creditors and investors increase their required rates of return as a company takes on debt. At first this increase is small, and the weighting toward lower-cost debt pushes the cost of capital down. Eventually, the rate at which creditors and investors increase their required rates of return accelerates and dominates the weighting toward debt, pushing the cost of capital back upward. The result is that the cost of capital declines with debt and reaches a minimum point before rising again. This approach concludes that there is a optimal financing mix consisting of some debt and some equity.

Explain Net income approach. Who proposed this theory? This is an approach in which both cost of debt, and equity are independent of capital structure. The components which are involved in it are constant and doesn't depend on how much debt the firm is using. This theory was proposed by David

Durand. In this change in financial leverage leads to change in overall cost of capital as well as total value of firm. If financial leverage increases, weighted average cost decreases and value of firm and market price of equity increases. If this decreases then weighted average cost of capital increases and value of firm and market price of equity decreases. The assumptions which can be made according to this approach is that there are no taxes involved in this and the use of debt doesn't change the risk factor for the investors and will remain the same throughout.
The Net Income theory and Net Operating Income theory stand in extreme forms. Traditional approach stands in the midway between these two theories. This Traditional theory was advocated by financial experts Ezta Solomon and Fred Weston. According to this theory a proper and right combination of debt and equity will always lead to market value enhancement of the firm. This approach accepts that the equity shareholders perceive financial risk and expect premiums for the risks undertaken. This theory also states that after a level of debt in the capital structure, the cost of equity capital increases. Net Income (NI) Approach Net Income theory was introduced by David Durand. According to this approach, the capital structure decision is relevant to the valuation of the firm. This means that a change in the financial leverage will automatically lead to a corresponding change in the overall cost of capital as well as the total value of the firm. According to NI approach, if the financial leverage increases, the weighted average cost of capital decreases and the value of the firm and the market price of the equity shares increases. Similarly, if the financial leverage decreases, the weighted average cost of capital increases and the value of the firm and the market price of the equity shares decreases.

Assumptions of NI approach:

There are no taxes The cost of debt is less than the cost of equity. The use of debt does not change the risk perception of the investors

NET INCOME APPROACH (NI)

Capital structure decision is relevant to the valuation of the firm A firm can minimise the overall cost of capital (WACC) by maximising the use of debt in its capital structure As a result, the market price of the shares and value of the firm will increases

ASSUMPTIONS NI APPROACH The cost of debt is less than the cost of equity There are no corporate taxes The use of debt does not alter the risk perceptions ofinvestors Formula: V=S+D; V= total market value of the firm S=market value of equity share D= market value of debt S=net income equity capitalisation rate (OR) earnings available to shareholders cost of equity (Ke)

Net Income (NI) Approach The effect of leverage on the cost of capital under NI approach
Net Income (NI) Approach

1.

According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they

remain constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the firm value increases with debt.

1.

This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach.

NET INCOME APPROACH This theory proposes that capital structure is relevant and that the proportionate use of debt in a firms capital structure will increase its value. It suggests that a firm can vary its value by either increasing or decreasing it through the financial mix, which is the ratio of debt to equity. The NI approach is based on the premise that the cost of debt is cheaper than that of equity and that the optimal use of debt will result in a decline in WACC. According to this approach, the average cost of capital (ko) declines as gearing increases. The cost of shareholders funds (ke) and the cost of debt (kd) are independent. Since kd is usually less than ke as debt is less risky than equity from the investors point of view, an increase in gearing should lead to a decrease in ko As the proponent puts it, the cost of debt is cheaper than that of equity for the following reasons; i. Lenders require a lower rate of return than ordinary shareholders. Debt finance presents a lower risk than shares for the finance providers because they have prior claims on annual income and liquidation. In addition security is often provided and covenant imposed. ii. A profitable business effectively pays less for debt capital than equity since debt interest can be offset against pre-tax profits before the calculation of company tax, thus reducing the companys tax liabilities. iii. Issuing and transaction costs associated with raising andservicing debt are generally less than for ordinary shares. The Net Income approach can be demonstrated graphically asfollows;

As shown, the cost of equity is constant throughout. An increase in the level of gearing is consistent with a reduction in the cost of capital. Thus, as a firm introduces more debt into its capital structure, the value of the firm has increased and the overall cost of capital will decline. Clearly, the amount of debt that a firm uses to finance its assets is called leverage. A firm that finances its assets by equity and debt is called a LEVERED/GEARED firm while a firm that finances its assets entirely with equity is an UNLEVERED firm. Hence, under the NI approach; Cost of Debt (Kd)= Interest Market Value of Debt Cost of Equity (Ke) = Earnings available to shareholders Market value of shares outstanding Value of the firm (V)= Mkt value of Debt + Mkt value of equity (V)= D + E Accordingly, under this approach, the firms overall cost of capital or expected rate of return (WACC) is expressed as; Cost of capital =Net Operating Income Value of firm Ko =NOIV On the whole, under this approach, the firm will achieve its maximum value and minimum WACC (Optimality) when it is 100% Debt financed Net Income Approach (NI) (Cost of Capital) and V (Total Mkt. Value) of the firm expensive source of funds increases in the capital structure, ko decreases and V of the firm increases. can evolve an optimum capital structure at which ko would be the lowest and the V of the firm highest and the market price per share the maximum

Assumptions

investors If the firm is using equity capital alone, the composite cost of capital will be equal to Ke and the value of the firm will be minimum.