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CS- Net Income Theory.pptx
1. Theories of Capital
Structure
A. Net Income Theory
Semester: 5
Sub.: Advance Financial Management
Module 2 (Part 2)
Prepared by: Dr. Sonam Arora
2. Capital Structure and Firm
Valuation
Objective: Every business aims to achieveOptimum Capital
Structure because it effects theValue of firm (V) either by
increasing expected earnings or by reducing the cost of
capital.
There are different views on how capital structure influence
the value of firm:
3. If other thing being
equal, increase in
financial leverage
(debt) increase the
value of firm
Relevant Theory
1. Net Income
Theory
There is no relationship
between Capital
Structure & Value of
firm
Irrelevant Theory
2. Net Operating
Income
Theory and 3.
Modigliani and
Miller Approach
Use of debt have
positive impact on
capital structure up to a
certain level and have
negative effect
thereafter
Neutral Theory
4. Traditional
Approach
4. 1. Net Income (NI) Approach
βͺ This approach is developed by David Durand in 1959.
Assumptions:
a.There are no taxes
b. Cost of debt is less than cost of equity
c. Cost of debt and cost of equity remains constant
d.The firm has perpetual life.
5. The capital structure decision are relevant to firm:
1. Change in capital structure (by increasing
debt)cause an overall change in ko and also in V
Introduce
higher debt in
capital
structure
Increase
financial
leverage
(risk)
This decline ko
(overall cost of
capital) orWACC
This increase
the value of
firm
Increase in
the value of
equity share
also
6. Explanation
According to Durand the
average cost of capital will
reduce with greater use of
debt and the equity
shareholders will not insist for
higher return with increased
levels of gearing caused by
the use of increasing level of
debt component.
Lenders will also not insist on
higher interest with
increasing level of debt.
7. Ex:
ABC Ltd. expects
operating profit (EBIT) of
Rs. 100000.The company
has raised 12% debentures
of Rs. 300000.The
company equity capital
cost is 13%. Determine the
value of firm (v) and overall
cost of capital.
Sol.:V = E + D
D = Rs. 300000 (given in sum)
E = ?
Net Income = EBIT 100000 β Int. 36000 = 64000 Rs.
Equity capital cost is 13% (given in sum)
Market value of equity = 64000/ 13%
= 492307
V = 492307 + 300000 = 7,92307 Rs.
Ko= EBIT/V = 100000/792307= 12.62%
8. Sum 1
Present Situation Situation A Situation B
Particulars
50% increase in
debt capital
50% decrease in
debt capital
8% Debentures 600000 900000 300000
EBIT 150000 150000 150000
ke 10% 10% 10%
V ?
Ko
