Page 133 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 7: Capital Structure Decision

5. The business risk is assumed to be constant and is not affected by the financing mix Notes
decision.
6. There are no corporate or personal taxes.
7. The investors have the same subjective probability distribution of expected earnings.

7.4.1 Net Income (NI) Approach

The Net Income (NI) approach is the relationship between leverage and cost of capital and value
of the firm. This theory states that there is a relationship between capital structure and the value
of the firm and therefore, the firm can affect its value by increasing or decreasing the debt
proportion in the overall financing mix. The NI approach makes the following additional
assumptions:
1. That the total capital requirement of the firm is given and remains constant.
2. That cost of debt is less than cost of equity capitalization rate.

3. There are no corporate taxes.
4. The use of debt content does not change the risk reception of the investors as a result; both
the debt capitalization rate and the equity capitalization rate remain constant.

Did u know? Who suggested NI Approach?
NI (Net Income) Approach is suggested by Durand.
The NI approach starts from the argument that change in financing mix of a firm will lead to
change in Weighted Average Cost of Capital (WACC) of the firm, resulting in the change in
value of the firm. As debt capitalization is less than equity, the increasing use of cheaper debt
(and simultaneous decrease in equity proportion) in the overall capital structure will result in
magnified returns to the shareholders.
The increased returns to the shareholders will increase the total value of the equity and this
increases the total value of the firm. The WACC will decrease and the value of the firm will
increase. On the other hand, if the financial leverage is reduced by the decrease in the debt
financing, the WACC of the firm will increase and the total value of the firm will decrease. The
NI approach to the relationship between leverage costs of capital has been presented graphically.
Figure 7.2: NI Approach

The value of the firm on the basis of Net income approach can be ascertained as follows: V= S+D.
Where

V = Value of the firm
S = Market value of equity.
D = Market value of debt.

LOVELY PROFESSIONAL UNIVERSITY 127