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Net Income Approach in Capital Structure

The document discusses how the net income approach suggests that a company's capital structure and leverage ratio can impact its value and overall cost of capital. Specifically, it states that if a company takes on more debt, which has a lower cost than equity, then its overall cost of capital will decrease, leading to an increase in the value of the firm and the market price of its shares. It lists some key assumptions, including that debt has a lower cost than equity and that investor risk perception is unchanged by debt levels. Finally, it includes a diagram showing the relationships between cost of equity, overall cost of capital, and cost of debt.

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40 views3 pages

Net Income Approach in Capital Structure

The document discusses how the net income approach suggests that a company's capital structure and leverage ratio can impact its value and overall cost of capital. Specifically, it states that if a company takes on more debt, which has a lower cost than equity, then its overall cost of capital will decrease, leading to an increase in the value of the firm and the market price of its shares. It lists some key assumptions, including that debt has a lower cost than equity and that investor risk perception is unchanged by debt levels. Finally, it includes a diagram showing the relationships between cost of equity, overall cost of capital, and cost of debt.

Uploaded by

Subash
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd

Net Income Approach

Net Income Approach suggested by The “Durand” the


capital structure decision is relevant to the valuation
of the firm or we can say change Leverage ratio will
lead to change in the value of the firm and overall cost
of capital.
If Rate is high( ) then Cost of capita is less( ), Value of
the firm will increase( ) and also Market price of the
share will increase( )
Assumptions

Cost of debt is lower than cost of equity.


Risk perception of investor is not changed by the use
of debt
No tax
Diagram

Ke = Cost of Equity
Ko = Cost of overall cost of capital
Kd = Cost of debt

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