NET INCOME APPROACH Homework Help

NET INCOME APPROACH

According to the Net Income (NI) Approach, suggested by the Durand, the capital structure decision is relevant to the Valuation of the firm. In other words a change in the financial leverage will lead to a corresponding change in the overall cost of capital as well as the total value of the firm, If, therefore, the degree of financial leverage as measured by the ratio of debt to equity is increased, the weighted average cost of capital will decline, while the value of the firm as well as the market price of ordinary shares will increase. Conversely, a decrease in the leverage will cause an increase in the overall cost of capital and a decline both in the value of the firm as well as the market price of equity shares.

The NI Approach to valuation is based on three assumptions: first, there are no taxes, second that the cost of debt is less than the equity-capitalization rate or the cost of equity: third. that the use does not change the risk perception of investors. That the financial risk perception of the change with the introduction of debt or change in leverage implies that due to change in leverage, there is no either the cost of debt or the cost of equity. The implication of the three assumptions underlying the N1 Approach is that as the degree of leverage increases, the proportion of a source of funds that is, debt in the capital structure increases, As a result, the weighted cost of capital to decline, leading to an increase in the total value of the firm. Thus, with the cost of debt and cost of equity being constant, the increased use of debt (increase in leverage), will magnify the share holder earnings and, there is the market value of the ordinary shares.

The financial leverage is, according to the NI Approach, an important variable to the capital structure of a firm. With a judicious mixture of debt and equity of firm can evolve an structure which will be the one at which value of the firm is the highest and the cost of capital is the lowest. At that structure, the market price per share would he maximum.

If the firm uses no debt or if the financial leverage is zero, the overall cost of capital will equal to the equity capitalization rate, The weighted average cost of capital will decline and approach the cost of debt is the degree of leverage reaches one.

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