9/6/2014 Capital Structure Theory - Net Income Approach

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Financial Leverage
Capital Structure Theory - Net Income Approach
Capital structure is the proportion of debt and equity in which a
corporate finances its business. The capital structure of a
company/firm plays a very important role in determining the value
of a firm. There are various theories which propagate the 'ideal'
capital mix / capital structure for a firm. One of the traditional
approaches is the Net Income Approach.
Introduction to Capital Structure Theory
A corporate can finance its business mainly by 2 means i.e. debts
and equity. However, the proportion of each of these could vary
from business to business. A company can choose to have a
structure which has 50% each of debt and equity or more of one
and less of another. Capital structure is also referred to as financial leverage, which strictly means the proportion of debt or
borrowed funds in the financing mix of a company.
Debt structuring can be a handy option because the interest payable on debts is tax deductible (deductible from net profit before
tax). Hence, debt is a cheaper source of finance. But increasing debt has its own share of drawbacks like increased risk of
bankruptcy, increased fixed interest obligations etc.
For finding the optimum capital structure in order to maximize shareholders wealth or value of the firm, different theories
(approaches) have evolved. Let us now look at the first approach
Net Income Approach Explained
Net Income Approach was presented by Durand. The theory suggests increasing value of the firm by decreasing overall cost of
capital which is measured in terms of Weighted Average Cost of Capital. This can be done by having higher proportion of debt,
which is a cheaper source of finance compared to equity finance.
Weighted Average Cost of Capital (WACC) is the weighted average costs of equity and debts where the weights are the amount of
capital raised from each source.
WACC =
Required Rate of Return x Amount of Equity + Rate of Interest x Amount of Debt
Total Amount of Capital (Debt + Equity)
According to Net Income Approach, change in the financial leverage of a firm will lead to corresponding change in the Weighted
Average Cost of Capital (WACC) and also the value of the company. The Net Income Approach suggests that with the increase in
leverage (proportion of debt), the WACC decreases and the value of a firm increases. On the other hand, if there is a decrease in
the leverage, the WACC increases and thereby the value of the firm decreases.
For example, vis--vis equity-debt mix of 50:50, if the equity-debt mix changes to 20: 80, it would have a positive impact on value
of the business and thereby increase the value per share.
Assumptions of Net Income Approach
Net Income Approach makes certain assumptions which are as follows.
Increase in debt will not affect the confidence levels of the investors.
The cost of debt is less than cost of equity.
There are no taxes levied.
Example
Consider a fictitious company with below figures. All figures in USD.
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Earnings before Interest Tax (EBIT) = 100,000
Bonds (Debt part) = 300,000
Cost of Bonds issued (Debt) = 10%
Cost of Equity = 14%
Calculating the value of a company
EBIT = 100,000
Less: Interest cost (10% of 300,000) = 30,000
Earnings after Interest Tax (since tax is assumed
to be absent)
= 70,000
Shareholders' Earnings = 70,000
Market value of Equity (70,000/14%) = 500,000
Market value of Debt = 300,000
Total Market value = 800,000
Overall cost of capital = EBIT/(Total value of firm)
= 100,000/800,000
= 12.5%
Now, assume that the proportion of debt increases from 300,000 to 400,000 and everything else remains same.
(EBIT) = 100,000
Less: Interest cost (10% of 300,000) = 40,000
Earnings after Interest Tax (since tax is assumed
to be absent)
= 60,000
Shareholders' Earnings = 60,000
Market value of Equity (60,000/14%) = 428,570 (approx)
Market value of Debt = 400,000
Total Market value = 828,570
Overall cost of capital = EBIT/(Total value of firm)
= 100,000/828,570
= 12% (approx)
As observed, in case of Net Income Approach, with increase in debt proportion, the total market value of the company increases
and cost of capital decreases.
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Add a comment 6 comments
Santhosh Pappu Lecturer at St. Aloysius Degree College, Bangalore
clear one very good
Reply Like 2 June at 05:06 1
Magar Bm Student at Shanker Dev College, Ktm
thanks for providing valuable knowledge.
Reply Like 23 May at 19:02