Net Income Approach

Net Income Approach : 

Net Income Approach optimum capital structure is one at which weighed average cost of capital is minimum and overall value of the firm is maximum. As the degree of financial leverage(Amount of Debt) increases in capital structure Value of the firm and value of equity shares increases and weighed average cost of capital decreases. The firm can employ almost 100% debt to maximize it’s value There are no taxes, cost of debt is less than cost of equity, use of debt does not change risk perception of investors.

Net operating Income : 

Net operating Income There is nothing as optimum capital structure Overall cost of capital/capitalization rate remains constant, residual value of equity(s=v-b), Changes in cost of equity. Explicit cost is the rate of interest of debt, implicit cost is increase in cost of equity due to increase in debt As the use of debt as a cheaper source is neutralized by the implicit cost

M-M Approach-Basic proposition : 

M-M Approach-Basic proposition Overall cost of capital and the value of the firm are independent of it’s capital structure Cost of equity is equal to capitalization rate of pure equity plus premium for financial risk Cut off rate for investment proposal is completely independent of the way investment are financed

M-M approach-Assumptions : 

M-M approach-Assumptions Perfect Capital market All investors have same perception about the of the firm’s EBIT Business risk is equal in among all the firm within similar environment i.e. firms can be divided between equivalent risk class and homogenous risk class. The dividend pay-our ratio is 100% No corporate taxes

Arbitrage process : 

Arbitrage process Implies buying a security in a market where price is low and selling where it is high. Homemade leverages can replicate the firm’s capital structure, thereby causing investor’s to be indifferent to it.

Limitation of the process : 

Limitation of the process Risk perception of corporate and personal leverage is different Personal leverages are more inconvenient If the borrowing cost vary, cost associated with personal and corporate borrowings will differ Intuitional restrictions stands in the way of smooth operation of the process Transaction cost Assumption of no taxes can not be observed in real world

Example of the process : 

Example of the process Two firms L & U identical in all respect except L has 10% Debentures of Rs. 500000, EBIT for the both firms is 1 00000 and equity capitalization rate of L is 16% and that of u is 12.5% Suppose Mr. holds 10% shares in L, then his earnings will be 5000 and share of holdings will be 31250. He sell his share in L and borrow additional 50000 His position in u will be investment cost 81250 total income(10156-5000)5156 instead of 5000 in U Thus Mr. X will be better of by selling securities in l and buying in U, other investors will follow same direction and prices of u will increase and prices of L will decreased. This will continue still it is possible to reduce investment outlay and get the same return Beyond this point switching from L to U will not be identical