This action might not be possible to undo. Are you sure you want to continue?
Net Income Approach
Capital Structure decision is relevant to the valuation
of the firm. In other words, a change in the financial leverage will lead to a corresponding change in the overall cost of capital as well as the total value of the firm. If therefore the degree of financial leverage as measured by the ratio of debt to equity is increased, the WACC will decline, while the value of the firm as well as the market price of share will increase and vice versa.
Assumption in Net Income Approach
First there are no taxes. Second the cost of debt is less than the cost of equity. Third the use of debt does not change the risk perception
A company’s expected annual EBIT is Rs. 50000. The company has Rs 2,00,000, 10% debenture. The cost of
equity of the company is 12.5%.
Net Operating Income (EBIT) Less: Interest on debentures (I) Earnings available to equity holders (NI) Equity Capitalization Rate (ke) Market Value of Equity (E) = NI/Ke Market Value of Debt (D) Total Value of the firm (E+D) = V Overall cost of capital = Ke = EBIT/V (%) Rs 50,000 20,000 30,000 0.125 2,40,000 2,00,000 4,40,000 11.36
Alternatively: Ko = Ki (D/V) + Ke (E/V)
There are 2 firms A and B similar in all aspects in
degree of leverage employed by them. Financial data is as follows
Firm A Operating Income (O) Interest on Debt (I) Equity Earnings (P) Cost of equity capital (rE) Cost of debt capital (rD) Market value of equity (E) Market value of debt (D) Total value of the firm (V) Average Cost of Capital (rA) = rD(D/V)+rE(E/V) 10000 0 10000 10% 6% 100000 0 100000 10% Firm B 10000 3000 7000 10% 6% 70000 50000 120000 8.33%
Net Operating Income Approach
Introduced by Mr. David Durand.
The Essence of this approach is that the capital structure decision of a firm is irrelevant.
Change in leverage does not lead to any change in total value of the firm and the market prices of the shares
The overall cost of capital (K) remains constant for all degrees of debt- equity mix.
The market capitalises the value of the firm as a
whole and therefore , the spilt between debt and equity is not relevant . The low cost debt increases the risk of equity shareholders , this results in increase in equity capitalization rate . An increase in the use of debt is offset by an increase in the equity capitalization rate .
Example of NOI Approach
Given: EBIT/NOI = Rs.50,000 Total debt outstanding = Rs.2,00,000 Cost of debt = 10% Overall cost of capital = 12.5% Ans: Value of the firm = EBIT/ overall cost of capital = 50,000/12.5% = 4,00,000 Value of equity = Value of the firm – value of debt = 4,00,000 – 2,00,000 = 2,00,000 Cost of equity = (EBIT- Int.)/ value of equity = (50,000 – 20,000) / 2,00,000 * 100 = 15%
Case 1: If the debt is increased to 3,00,000. Value of the firm = 4,00,000……remains constant Value of equity = 4,00,000 – 3,00,000 = 1,00,000 Cost of equity = (50000- 30000)/ 1,00,000* 100 = 20% Case 2: If the debt is decreased to 1,00,000. Value of the firm= 4,00,000….. remains constant Value of equity = 4,00,000 – 1,00,000 = 3,00,000 Cost of equity = (50000- 10000)/ 3,00,000 * 100 = 13.33%
Main propositions are – Cost of debt remains more or less constant upto a certain degree of leverage and then remains stable and thereafter rises at an increasing rate. Cost of equity remains more or less constant upto a certain degree of leverage and rises sharply thereafter.
The average cost of capital as the consequence of the
above behavior of cost of debt and cost of equity is as follows – a) Decreases upto a certain point b) Remains more or less unchanged for moderate increases in leverage c) Rises beyond that at an increasing rate.