The Net Income (NI) approach proposes that a firm's value increases as it takes on more debt financing due to debt generally being a cheaper source of capital than equity. According to the NI approach, the costs of debt and equity remain constant regardless of capital structure, so the overall cost of capital declines as debt levels rise. However, the NI approach assumes unrealistic conditions like taxes being ignored and that more debt does not affect investor risk perceptions. It implies the maximum firm value occurs with 100% debt financing.

1. NET INCOME
APPROACH
BY : SIMI.P M

2. Net Income (NI) approach
• This theory was propounded by David Durand and also known as Fixed ke theory.
• According to this approach the value of the firm is increase and decrease overall
cost of capital by increasing the proportion of debt financing in capital structure.
• It is due to the fact that debt is generally a cheaper source of finance because:
1) interest rate is lower than the dividend rate
2) benefit of tax because int. is deductible expense.
•

3. Cont…
• both the cost of debt and cost of equity are independent of the capital
structure; they remain constant regardies of how much debt the firm uses.
As the result ,the overall cost of capital decline and the firm value increases
with the debt.
• This approach has no basis in reality; the optium capital structure would be
100 % debt financing under NI approach.

4. Cont…
• ie., cost of debt = interest market value of debt
cost of equity= earnings available to shareholders , market value of
shares outstanding
value of the firm = market value of debt + market value of equity.
• accordingly, under this approach, the firm’s overall cost of capital or
expected rate of return (WACC) is expressed as:
cost of capital = net operating income value of firm.

5. formula
• V= S+D
where, V= the total market value
S= market value of equity share, net income equity capitalization rate
D= market value of debt

6. Assumptions of NI approach
• There are no taxes
• The cost of debt is less than the cost of equity
• The uses of debt does not change the risk perception of the investors.
if the firm is using equity capital alone , the composite cost of capital will
equal to cost of equity and the value of the firm will be minimum.
.