Net Income (NI) Approach

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

Example

A company expects its annual EBIT to be $50,000. The company has $200,000 in 10% bonds and the cost of equity is 12.5(ke)%.

Calculation of the Value of the firm:
   

Effect of change in the capital structure: (Increase in debt capital)

Let us assume that the firm decides to retire $100,000 worth of equity by using the proceeds of new debt issue worth the same amount. The cost of debt and equity would remain the same as per the assumptions of the NI approach. This is because one of the assumptions is that the use of debt does not change the risk perception of the investors.

Calculation of new value of the Firm

   

Please note:

Overall cost of capital can also be calculated by using the weights of debt and equity contents with the respective cost of capitals.

This proves that the use of additional financial leverage (debt) causes the value of the firm to increase and the overall cost of capital to decrease.

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