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What is Net Income Approach?


Net Income Approach: This approach is developed by David Durand. According this approach the cost of debt is cheaper then cost of equity. So, in capital structure increase the debt capital in comparison to equity to reduce the overall cost of capital. The value of the firm can be increase or decrease by increasing or decreasing the overall cost of capital. As more debt is used in capital structure the lesser will be the overall cost of capital or weighted average cost of capital.  The value of the firm increases if the overall cost of capital decreases. So, the value of firm increases if more debt capital is used. When the cost of equity is more in capital structure then the overall cost of capital is increases and the value of the firm decreases. It shows that the change in capital structure will lead to change in value of the firm.

Assumptions of Net Income approach:
·         The cost of debt is cheaper then cost of equity.
·         There is no corporate tax.
Formula:
V = S + B
S = NI / Ke
Ko = EBIT / V
Where,
V = Value of firm
NI = Net income or earnings available for shareholders
Ke = Cost of equity or equity capitalisation rate
Ko = Overall cost of capital
S = Market value of equity
B = Market value of debt

Example: Find out the value of the firm if the overall cost of capital is 12% and the earnings before interest and tax are Rs.4, 60,000.
Solution: V = EBIT / Ko
= 4, 60, 000 / 0.10
=Rs. 46, 00, 000

Example: Find out the value of the firm and the overall cost of capital with the help of net income approach. XYZ Company has 6% debenture is Rs. 3, 00, 000 and the earnings before interest and tax are Rs. 5, 00,000. The equity capitalisation rate is 8%.

Solution:
Particulars
Amount (in Rs.)
Earnings before interest and tax (EBIT)
5, 00,000
Less: interest on debenture
(18, 000)
Earnings available for shareholders
4, 82,000
equity capitalisation rate
8%
Market value of equity ((4,82,000/8)*100)
60, 25, 000
Market value of debenture or debt
3, 00,000
Value of the firm (S+B)
63, 25,000
Overall cost of capital *(EBIT / V)
7.91%

Ko = (5, 00, 000/ 63, 25,000)*100 = 7.91%

Example: Calculate the value of firm and the overall cost of capital if the debenture increases by Rs. 3, 00, 000. The EBIT of PQR Company is Rs. 2, 00, 000. The capitalisation rate is 5%. Company has Rs. 2, 00,000 6% debenture.

Solution:
Particulars
Amount (in Rs.)
Earnings before interest and tax (EBIT)
2, 00,000
Less: Interest on Rs.2, 00, 000 debenture
(12, 000)
Earnings available for shareholders  (NI)
1, 88, 000
equity capitalisation rate
12%
Market value of equity (1, 88,000/10)*100)
18, 80, 000
Market value of debenture or debt
2, 00,000
Value of the firm (S+B)
20, 80,000
Overall cost of capital (EBIT / V)
9.62%

If Debenture increases by Rs. 3, 00,000:

Particulars
Amount (in Rs.)
Earnings before interest and tax (EBIT)
2, 00,000
Less: interest 6% debenture of Rs. 5, 00,000
(30, 000)
Earnings available for shareholders
1, 70,000
equity capitalisation rate
10%
Market value of equity ((1,70,000/10)*100)
17, 00, 000
Market value of debenture or debt
5, 00,000
Value of the firm (S+B)
22, 00,000
Overall cost of capital *(EBIT / V)
9.09%

It shows that increase in debt capital in capital structure the overall cost of capital is decreases and the value of firm has increase.

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