Capital Structure Theory - Net Income Approach

9/6/2014 Capital Structure Theory - Net Income Approach

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Financial LeverageCapital Structure Theory - Net Income Approach

Capital structure is the proportion of debt and equity in which a

corporate finances its business. The capital structure of a

company/firm plays a very important role in determining the value

of a firm. There are various theories which propagate the 'ideal'

capital mix / capital structure for a firm. One of the traditional

approaches is the Net Income Approach.

Introduction to Capital Structure Theory

A corporate can finance its business mainly by 2 means i.e. debts

and equity. However, the proportion of each of these could vary

from business to business. A company can choose to have a

structure which has 50% each of debt and equity or more of one

and less of another. Capital structure is also referred to as financial leverage, which strictly means the proportion of debt or

borrowed funds in the financing mix of a company.

Debt structuring can be a handy option because the interest payable on debts is tax deductible (deductible from net profit before

tax). Hence, debt is a cheaper source of finance. But increasing debt has its own share of drawbacks like increased risk of

bankruptcy, increased fixed interest obligations etc.

For finding the optimum capital structure in order to maximize shareholders wealth or value of the firm, different theories

(approaches) have evolved. Let us now look at the first approach

Net Income Approach Explained

Net Income Approach was presented by Durand. The theory suggests increasing value of the firm by decreasing overall cost of

capital which is measured in terms of Weighted Average Cost of Capital. This can be done by having higher proportion of debt,

which is a cheaper source of finance compared to equity finance.

Weighted Average Cost of Capital (WACC) is the weighted average costs of equity and debts where the weights are the amount of

capital raised from each source.

WACC =

Required Rate of Return x Amount of Equity + Rate of Interest x Amount of Debt

Total Amount of Capital (Debt + Equity)

According to Net Income Approach, change in the financial leverage of a firm will lead to corresponding change in the Weighted

Average Cost of Capital (WACC) and also the value of the company. The Net Income Approach suggests that with the increase in

leverage (proportion of debt), the WACC decreases and the value of a firm increases. On the other hand, if there is a decrease in

the leverage, the WACC increases and thereby the value of the firm decreases.

For example, vis--vis equity-debt mix of 50:50, if the equity-debt mix changes to 20: 80, it would have a positive impact on value

of the business and thereby increase the value per share.

Assumptions of Net Income Approach

Net Income Approach makes certain assumptions which are as follows.

Increase in debt will not affect the confidence levels of the investors.

The cost of debt is less than cost of equity.

There are no taxes levied.

Example

Consider a fictitious company with below figures. All figures in USD.

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Earnings before Interest Tax (EBIT) = 100,000

Bonds (Debt part) = 300,000

Cost of Bonds issued (Debt) = 10%

Cost of Equity = 14%

Calculating the value of a company

EBIT = 100,000

Less: Interest cost (10% of 300,000) = 30,000

Earnings after Interest Tax (since tax is assumed

to be absent)

= 70,000

Shareholders' Earnings = 70,000

Market value of Equity (70,000/14%) = 500,000

Market value of Debt = 300,000

Total Market value = 800,000

Overall cost of capital = EBIT/(Total value of firm)

= 100,000/800,000

= 12.5%

Now, assume that the proportion of debt increases from 300,000 to 400,000 and everything else remains same.

(EBIT) = 100,000

Less: Interest cost (10% of 300,000) = 40,000

Earnings after Interest Tax (since tax is assumed

to be absent)

= 60,000

Shareholders' Earnings = 60,000

Market value of Equity (60,000/14%) = 428,570 (approx)

Market value of Debt = 400,000

Total Market value = 828,570

Overall cost of capital = EBIT/(Total value of firm)

= 100,000/828,570

= 12% (approx)

As observed, in case of Net Income Approach, with increase in debt proportion, the total market value of the company increases

and cost of capital decreases.



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Add a comment 6 comments

Santhosh Pappu Lecturer at St. Aloysius Degree College, Bangalore

clear one very good

Reply Like 2 June at 05:061

Magar Bm Student at Shanker Dev College, Ktm

thanks for providing valuable knowledge.

Reply Like 23 May at 19:02

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Capital Structure Theory - Net Income Approach