Net Income Approach by Durand

544 Words Feb 2nd, 2018 2 Pages
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.
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-à-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. o Increase in debt will not affect the confidence levels of the investors. o The cost of debt is less than cost of equity. o There are no taxes levied

Diagrammatic representation of NI Approach to Capital Structure:

NET OPERATING INCOME APPROACH (NOI) Net Operating Income Approach suggests that change in debt of the firm/company or the change in…
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