f.m net income approach

1. PRESENTED BY
SONALI MOHANTY
18MBA(FM)009
PALLISHREE LENKA
18MBA(FM)010

2. Capital is the fund required to initiate the activities of any business.
It is the foundation of business finance.
Capital is the decision relating to arrangement of required capital through long
term instruments
The composition of long term financing in the form of equity , debt and retained
earnings is known as capital structure.

3. NET INCOME APPROACH
Net income approach has been propounded by Durand David in 1959.According to this approach the
market value of equity shares is based on earning available for equity shareholders after the payment of
interest on debt if it is included in capital structure. The earning of the firm after the payment of all other
expanses except interest on debt is called net operating income and the earning available for equity
shareholders after the payment of interest is called net income.
Therefore,Net income=net operating income-interest on debt
As per the preposition of this theory the value of equity shares is decided on the basis of net income
available for equity shareholders. The market value of the firm is decided by adding the value of debt and
value of equity shares.as the net income and cost of capital differs with the use of debt in capital structure
the value of equity shares also change accordingly . This phenomenon ultimately changes the value of firm
and hence as per this approach capital structure decision becomes relevant to the valuation of the firm.in
other words change in the capital structure brings a corresponding change in the overall cost of capital as
well the total value of the firm.
According to this approach as the debt increases overall or weighted average cost of capital decreases and
vice versa . Therefore increase in debt results in the increase in the value of the firm and consequently
increases the value of equity shares of the company.

4. ASSUMPTIONS
There are no corporate taxes.
The cost of debt is less than the cost of equity.
The cost of debt and cost of equity remains constant.
Dividend payout ratio is 100%.
The increase in debt will not affect the confidence level of the investors.

5. VALUE OF EQUITY (E) = NI/Ke
Value of debt(D) = I/Kd
Value of the firm(v) = E+D
Firm’s cost of capital(ko) = NOI/V
Where,
NI= Net Income
Ke = Cost of Equity
Kd = Cost of debt
V =Value of the firm
NOI=Net operating income

6. Zero debt 5%
Rs 300,000
debt
5%
Rs 9,00,000
debt
Net operating
incomeNOI
100,000 100,000 100,000
TOTAL COST OF
DEBT, INT = Kd D
0 15,000 45,000
Net income,
NI: NOI-INT
1,00,000 85,000 55,000
Market value of
equity E=NI/Ke
1,000,000 8,50,000 5,50,000
Market value of
debt,D : INT/Kd
0 3,00,000 9,00,000
Market value of
the firm,
V=E+D=NOI/Ko
1,000,000 1,150,000 1,450,000
Debt/Total value,
D/V
0.00 0.261 0.62
WACC,
NOI/V=
0.100 0.087 0.081
E
X
A
M
P
L
E

7. WORKING
The value of the firm is equal to the sum of values of all securities ;
E= NOI – INTEREST / Ke = NI / Ke = 85,000/0.10 = Rs 850,000
D=INTEREST/Kd= 15,000/0.05= Rs 300,000
V=E+D=850,000+300,000= Rs 1,150,000
The weighted average cost of capital, ko, is :
Ko = NOI / V = 1,00,000/1,150,000 = 0.087 OR 8.7 %

8. Ke
Ko
Kd
Degree of leverage
Costofcapital

9. Explanation of graph :
From the diagram, it is clear that as the debt is replaced by equity in the
capital structure the weighted average cost of capital (Ko) decreases. The
WACC decreases because the debt is cheaper than the equity and therefore
as the debt increases and equity reduces, the funds having less cost is
replaced by the funds having more cost.
As per this approach the cost of capital is minimum at 100% level of debt,
therefore the capital structure is optimized at the 100 % debt level.

10. CRITICISMS OF NET INCOME APPROACH
 The assumption of constant cost of debt at any level of
debt is not correct.The fund providers insist for more rate
of interest above certain level of debt.
 The assumption of risk perception of equity shareholders is
also not correct as the debt increases the financial risk also
increases .
 100% dividend payout and absence of corporate tax are
not practically possible.