net income approach
TRANSCRIPT
NET INCOME APPROACH
The net income approach, net operating income approach, and traditional
approach are three theoretical frameworks for how a company should set its
debt-equity mix. All three examine how a company's cost of capital changes with
the debt-equity mix and search for the lowest value of the cost of capital, hence
the maximum value of the firm, to identify the best mix. They reach
different conclusions because they make different assumptions about creditors'
and investors' reactions to increasing debt. Each of us will have our own
feelings about the reasonableness of the assumptions. Without going into the
Modigliani-Miller mathematics, the assumptions of the traditional approach
usually seem most reasonable to most people.
(1) The net income approach makes the simplest assumptions, that
neither creditors nor investors increase their required rates of return as a
company takes on debt. The cost of capital declines as higher-cost equity
is replaced with lower-cost debt. This approach concludes that the
optimal financing mix is all debt.
(2) The net operating income approach assumes that creditors do not
increase their required rate of return as a company takes on debt, but
investors do. Further, the rate at which investors increase their required
rate of return as the financing mix is shifted toward debt exactly offsets
the weighting away from the more expensive equity and toward the
cheaper debt. The result is that the cost of capital remains constant
regardless of the financing mix. This approach concludes that there is no
optimal financing mix-any mix is as good as any other.
(3) The traditional approach assumes that both creditors and investors
increase their required rates of return as a company takes on debt. At
first this increase is small, and the weighting toward lower-cost debt
pushes the cost of capital down. Eventually, the rate at which creditors
and investors increase their required rates of return accelerates and
dominates the weighting toward debt, pushing the cost of capital back
upward. The result is that the cost of capital declines with debt and
reaches a minimum point before rising again. This approach concludes
that there is a optimal financing mix consisting of some debt and some
equity.
Explain Net income approach. Who proposed this theory?
This is an approach in which both cost of debt, and equity are independent of capital structure. The components which are involved in it are constant and doesn't depend on how much debt the firm is using. This theory was proposed by David Durand. In this change in financial leverage leads to change in overall cost of capital as well as total value of firm. If financial leverage increases, weighted average cost decreases and value of firm and market price of equity increases. If this decreases then weighted average cost of capital increases and value of firm and market price of equity decreases. The assumptions which can be made according to this approach is that there are no taxes involved in this and the use of debt doesn't change the risk factor for the investors and will remain the same throughout.
The Net Income theory and Net Operating Income theory stand in
extreme forms. Traditional approach stands in the midway between
these two theories. This Traditional theory was advocated by
financial experts Ezta Solomon and Fred Weston. According to this
theory a proper and right combination of debt and equity will always
lead to market value enhancement of the firm. This approach
accepts that the equity shareholders perceive financial risk and
expect premiums for the risks undertaken. This theory also states
that after a level of debt in the capital structure, the cost of equity
capital increases.
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
NET INCOME APPROACH (NI)
Capital structure decision is relevant to the valuation of the firm
A firm can minimise the overall cost of capital (WACC) by maximising the use of debt in its capital structure
As a result, the market price of the shares and
value of the firm will increases
ASSUMPTIONS – NI APPROACH
The cost of debt is less than the cost of equity
There are no corporate taxes
The use of debt does not alter the risk perceptions ofinvestors
Formula:
V=S+D; V= total market value of the firm
S=market value of equity share
D= market value of debt
S=net income equity capitalisation rate
(OR)
earnings available to shareholders
cost of equity (Ke)
Net Income (NI) Approach
The effect of leverage on the cost of capital under NI approach
Net Income (NI) Approach
1. According to NI approach both the cost of debt and the cost of equity are independent of the capital
structure; they remain constant regardless of how much debt the firm uses. As a result, the overall
cost of capital declines and the firm value increases with debt.
1. This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing
under NI approach.
NET INCOME APPROACH
This theory proposes that capital structure is relevant and that the proportionate use of debt in a firm’s capital structure will increase its value. It suggests that a firm can vary its value by either increasing or decreasing it through the financial mix, which is the ratio of debt to equity.
The NI approach is based on the premise that the cost of debt is cheaper than that of equity and that the optimal use of debt will result in a decline in WACC.
According to this approach, the average cost of capital (ko) declines as gearing increases. The cost of shareholders funds (ke) and the cost of debt (kd) are independent. Since kd is usually less than ke as debt is less risky than equity from the investor’s point of view, an increase in gearing should lead to a decrease in ko
As the proponent puts it, the cost of debt is cheaper than that of equity for the following reasons;
i. Lenders require a lower rate of return than ordinary shareholders. Debt finance presents a lower risk than shares for the finance providers because they have prior claims on annual income and liquidation. In addition security is often provided and covenant imposed.
ii. A profitable business effectively pays less for debt capital than equity since debt interest can be offset against pre-tax profits before the calculation of company tax, thus reducing the company’s tax liabilities.
iii. Issuing and transaction costs associated with raising andservicing debt are generally less than for ordinary shares.
The Net Income approach can be
demonstrated graphically asfollows;
As shown, the cost of equity is constant throughout. An increase in the level of gearing is consistent with a reduction in the cost of capital.
Thus, as a firm introduces more debt into its capital structure, the value of the firm has increased and the overall cost of capital will decline.
Clearly, the amount of debt that a firm uses to finance its assets is called leverage.
A firm that finances its assets by equity and debt is called a LEVERED/GEARED firm while a firm that finances its assets entirely with equity is an UNLEVERED firm.
Hence, under the NI approach;
Cost of Debt (Kd)= Interest Market Value of Debt
Cost of Equity (Ke) = Earnings available to shareholders Market value of shares outstanding
Value of the firm (V)= Mkt value of Debt + Mkt value of equity
(V)= D + E
Accordingly, under this approach, the firm’s overall cost of capital or expected rate of return (WACC) is expressed as;
Cost of capital =Net Operating Income Value of firm
Ko =NOIV
On the whole, under this approach, the firm will achieve its maximum value and minimum WACC (Optimality) when it is 100% Debt financed
Net Income Approach (NI)
Capital structure is relevant as it affects the ko (Cost of Capital) and V (Total Mkt. Value) of the firm
Core of the approach: As the ratio of less expensive source of funds increases in the capital structure, ko decreases and V of the firm increases.
With a judicious mix of debt and equity a firm can evolve an optimum capital structure at which ko would be the lowest and the V of the firm highest and the market price per share the maximum
Assumptions
No corporate taxCost of debt is less than cost of equityUse of debt does not change the risk perception of investors
If the firm is using equity capital alone, the composite cost of capital will be equal to Ke and the value of the firm will be minimum.