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Financial Management - CAPITAL STRUCTURE THEORIES

Net Income Approach

   Posted On :  20.06.2018 03:36 am

Any company is said to have leveraged if it finances its assets through debt capital and equity capital. On the other hand, a company which finances its assets entirely through equity capital is called an unlevered company.

Net Income Approach
 
Any company is said to have leveraged if it finances its assets through debt capital and equity capital. On the other hand, a company which finances its assets entirely through equity capital is called an unlevered company.
 
The value of equity of any company can be found out by discounting its net income V (value of equity) = E (net income) / K (cost of equity)
 
Similarly the value of a company’s debt can be found out by discounting the value of interest on debt.
 
V (value of debt) = I (interest on debt) / K (cost of debt)
 
The value of the company will be the sum value of value of equity and value of debt. The company’s overall cost of capital is called the weighted average cost of capital (detailed coverage is given below) and this can be found as under
We know,
 
Value of the firm = value of its equity + value of its debt
 
Company’s cost of capital = Net operating income / value of the firm
 
There is another way to calculate weighted average cost of capital.
 
WACC = Cost of equity X equity weight + cost of debt X debt weight
 
Net income approach reveals that the cost of debt Rd, the cost of equity Re remain unchanged when Debt / Equity varies. The constancy of cost of debt and cost of equity with regard to D/E means that Ra, the average cost of capital is measured as under
 
Ra = Rd  [D / (D+E)] + Re [E / (D+E)]
 
The average cost of capital Ra will decrease as D/E increases. 
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