Net Income (NI) Approach
Net income approach suggested by the Durand. According to this approach, the capital
structure decision is relevant to the valuation of the firm. In other words, a change in the
capital structure leads to a corresponding change in the overall cost of capital as well as the
total value of the firm.
According to this approach, use more debt finance to reduce the overall cost of capital
and increase the value of firm.
Net income approach is based on the following three important assumptions:
1. There are no corporate taxes.
2. The cost debt is less than the cost of equity.
3. The use of debt does not change the risk perception of the investor.
where
V = S+B
V = Value of firm
S = Market value of equity
B = Market value of debt
Market value of the equity can be ascertained by the following formula:
S =NI/Ke
where
NI = Earnings available to equity shareholder
Ke = Cost of equity/equity capitalization rate
Format for calculating value of the firm on the basis of NI approach.
Particulars Amount
Net operating income (EBIT) XXX
Less: interest on debenture (i) XXX
Earnings available to equity holder (NI) XXX
Equity capitalization rate (Ke) XXX
Market value of equity (S=NI/K ) XXX
Market value of debt (B) XXX
Total value of the firm (S+B) XXX
Overall cost of capital = Ko = EBIT/V(%) XXX%
Net Operating Income (NOI) Approach
Another modern theory of capital structure, suggested by Durand. This is just the opposite
to the Net Income approach. According to this approach, Capital Structure decision is
irrelevant to the valuation of the firm. The market value of the firm is not at all affected by
the capital structure changes.
According to this approach, the change in capital structure will not lead to any change
in the total value of the firm and market price of shares as well as the overall cost of capital.
NI approach is based on the following important assumptions;
The overall cost of capital remains constant;
There are no corporate taxes;
The market capitalizes the value of the firm as a whole;
Value of the firm (V) can be calculated with the help of the following formula
V =EBIT/Ko
Where,
V = Value of the firm
EBIT = Earnings before interest and tax
Ko = Overall cost of capital
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