Net Income (NI) Approach

Net Income theory was introduced by David Durand. According to this approach, the capital structure decision is relevant to the valuation of the firm. This means that a change in the financial leverage will automatically lead to a corresponding change in the overall cost of capital as well as the total value of the firm.

According to NI approach, if the financial leverage increases, the weighted average cost of capital decreases and the value of the firm and the market price of the equity shares increases. Similarly, if the financial leverage decreases, the weighted average cost of capital increases and the value of the firm and the market price of the equity shares decreases.

Assumptions of NI approach

There are no taxes The cost of debt is less than the cost of equity. The use of debt does not change the risk perception of the investors

A ltd is expecting an annual Ebit of Rs.1000000.the company has Rs.4000000 in 10%debenture. The equity capitalisation rate is 12.5%. The company decides to raise Rs.1000000 by issue of 10% debenture and use proceeds there of two buy back and cancel the equity shares. You are required to calculate The total value of the firm The overall cost of capital before and after the issue of fresh debenture for redeeming equity shares