Fm net income approach

f.m net income approach

1. CAPITAL STRUCTURE NET INCOME APPROACH PRESENTED BY SONALI MOHANTY 18MBA(FM)009 PALLISHREE LENKA 18MBA(FM)010

2. CAPITAL STRUCTURE 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 D avid 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. FORMULA 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 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 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= Ke × E/V + Kd × D/V 0.100 0.087 0.081 EXAMPLE

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 Cost of capital

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.