It is interesting to note that the NI approach can also be graphically presented as under with the help of the above illustration: This assumption is relaxed later on. Firms can be grouped into homogeneous risk classes. The following are the basic definitions: Under the net income Nl approach, the cost of debt and cost of equity are assumed to be independent of the capital structure.
Thus, the traditional position implies that the cost of capital is not independent of the capital structure of the firm and that there is an optimal capital structure. According to this view, the value of the firm can be increased or the cost, of capital can be reduced by the judicious mix of debt and equity capital.
Hence, debt is a cheaper source of finance. At that optimal structure, the marginal real cost of debt explicit and implicit is the same as the marginal Real cost of equity in equilibrium. From the above table it is quite clear that the value of the firm V will be increased if there is a proportionate increase in debt capital but there will be a reduction in overall cost of capital.
The traditional approach explains that up to a certain point, debt-equity mix will cause the market value of the firm to rise and the cost of capital to decline.
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In order to grasp the capital structure and the cost of capital controversy property, the following assumptions are made: However, M-M maintain that even if the cost of debt, Kd, is increasing, the weighted average cost of capital, Ko, will remain constant.
The theory suggests increasing value of the firm by decreasing the overall cost of capital which is measured in terms of Weighted Average Cost of Capital. Thus, the value of the firm, V, is ascertained at overall cost of capital Kw: As a result, the weighted average cost of capital remains constant and the total of the firm also remains constant as average changed.
This is because one of the assumptions is that the use of debt does not change the risk perception of the investors.
Thus, there are some distinct variations in this theory. The traditional view is a compromise between the net income approach and the net operating approach.
This conclusion could be valid if the cost of borrowings, Kd remains constant for any degree of leverage. It defines the cost of equity, follows from their proposition, and derived a formula as follows: Practically, this approach encompasses all the ground between the net income approach and the net operating income approach i.
According to this approach, the capital structure decision is relevant to the valuation of the firm. It is found from the above, the average cost curve is U-shaped. Assumptions of NI approach: 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.
After attaining that level only, the investors apprehend the increasing financial risk and penalize the market price of the shares.
The firm has a policy of paying per cent dividends. The expected NOI is a random variable 4. Our tutors are highly qualified and hold advanced degrees.
For degree of leverage before that point, the marginal real cost of debt is less than of equity, beyond that point the marginal real cost of debt excess that of equity. Net Operating Income Approach: The traditional approach can graphically be represented as under taking the data from the previous illustration.
No corporate income taxes exist. According to NI approach a firm may increase the total value of the firm by lowering its cost of capital.
If we draw a perpendicular to the X-axis, the same will indicate the optimum capital structure for the firm. So, the weighted average Cost of Capital Kw and Kd remain unchanged for all degrees of leverage.
There are no taxes, and iii.The net operating income approach, on the other hand, contends that the capital structure does not matter, and that the firm cannot affect its overall cost of capital through leverage. NET INCOME APPROACH This theory proposes that capital structure is relevant and that the proportionate use of debt in a firm’s 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 5/5(1). David Durand proposed the net income approach to capital structure. This approach looks at the consequence of alterations in capital structure in terms of net operating income.
Under this approach, on the basis of net operating income, the overall value of the firm is measured. Under the net income (Nl) approach, the cost of debt and cost of equity are assumed to be independent of the capital structure.
The weighted average cost of capital declines and the total value of the firm rise with increased use of average. Hence, optimum capital structure in this case is considered as Equity Capital Rs. 1,00, and Debt Capital Rs. 1,00, which bring the lowest overall cost of.
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.Download