304 FIN: AFM

Unit 2: Net Income Approach

Dr. Bhagyashree S Kunte

Dr. Bhagyashree Kunte 1

 Unit II: Net Income Approach
Net Income Approach:

This approach was introduced by David Durand.

According to this approach, the capital structure decision is

relevant to the valuation of the firm.

As such a change in the capital structure causes an overall change

in the cost of capital and also in the total value of the firm.

A higher debt content in the capital structure means a high

financial leverage and this results in decline in the WACC.

Dr. Bhagyashree Kunte 2
 Unit II: Net Income Approach
Durand (1952) suggested that, the average cost of capital will

reduce with greater use of debt and the equity shareholders will

not insist for higher return with increased levels of gearing

caused by the use of increasing level of debt component.

It is also assumed that the lenders will also not insist for higher

return with increasing levels of debt. Hence, the average cost

of capital falls until the level of debt is reached since there is

no upturn in the cost either equity or debt.

Dr. Bhagyashree Kunte 3
Unit II: Net Income Approach
 Net Income Approach by Durand
Cost of
Capital Cost of Equity

WACC

Cost of Debt

0
Degree of leverage

Dr. Bhagyashree Kunte 4

Unit II: Net Income Approach
Assumptions:
There are usually three basic assumptions of this
approach:
(a) Corporate taxes do not exist.
(b) Debt content does not change the risk perception of the
investors.
(c) Cost of debt is less than cost of equity i.e., debt
capitalisation rate is less than the equity capitalisation rate.

Dr. Bhagyashree Kunte 5

Unit II: Net Income Approach
According to net income approach, the value of the firm
and the value of equity are determined as given below:
Value of Firm (V) = S + B
Where, S = Market Value of Equity
B = Market Value of Debt
Market Value of Equity (S) = NI/Ke
Where, NI = Net income available for equity shareholders
Ke = Equity capitalization rate

Dr. Bhagyashree Kunte 6

Unit II: Net Income Approach
PPBIT= 25 lakhs
Equity= 5,00,000 @ 10 each capitalization @ 15%
Debentures= 30,000@ 100each Interest rate 12 %
Total Debenture =30,000*100= 30,00,000
Interest= 30,00,000*12% = 3,60,000
PBIT = 25,00,000
Less Interest = 3, 60,000
Profit for equity = 21,40,000
Equity capital = 21,40,000/0.15 = 1,42,66,667
Total value of the firm = 172, 66,667

Dr. Bhagyashree Kunte 7

Unit II: Net Income Approach
PPBIT= 20 lakhs
Equity= 4,00,000 @ 10 each capitalization @ 16%
Debentures= 40,000@ 100each Interest rate 12 %
Total Debenture =30,000*100= 30,00,000
Interest = 3,60,000
PBIT = 20,00,000
Less Interest = 3,60,000
PBT/ for equity = 16,40,000
Market Value of Equity = 16,40,000/.16 = 1,02,50,000
Value of firm = 1,02,50,000+ 30,00,000 = 132,50,000

Dr. Bhagyashree Kunte 8

Unit II: Net Income Approach
Qu. 1) Glamour Ltd. earned a profit of Rs. 20 lakhs before
providing for interest and tax.
The company’s capital structure is as follows:
(i) 4,00,000 Equity shares of Rs. 10 each and its market
capitalisation rate is 16%.
(ii) 25,000 14% Secured redeemable debentures of Rs. 150 each.
You are required to calculate the value of the firm under ‘Net
Income Approach’. Also calculate the overall cost of capital of
the firm.

Dr. Bhagyashree Kunte 9

Unit II: Net Income Approach
Solution 1:
Value of the Firm (V) = S + B
Where, S = Market value of equity
B = Market value of debt
Total Debts =25000*150 = 37,50,000
Cost of Debt: @14% : 5,25,000
PBIT = 20,00,000
Less: Cost of debt= 5,25,000
Earnings for Equity = 14,75,000
S = NI/ Ke 14,75,000/.16 = 92,18,750
V= S + B = 92,18,750 + 37,50,000 = 1,29,68750

Dr. Bhagyashree Kunte 10

Unit II: Net Income Approach
Qu.2) A company’s expected annual net operating income (EBIT)
is Rs. 50,000. The company has Rs. 2,00,000, 10% debentures.
The equity capitalisation rate (Ke) of the company is 12.5%.
Find the value of the firm and over all cost of capital under Net
Income approach.
Solution : Calculation of value of firm and overall cost of
capital under Net Income approach
Value of firm = MV of Equity (S) + MV of Debt (B)
EBIT = Rs. 50,000
Interest on debentures: 10% on 2,00,000 = Rs. 20,000
EBT = Rs. 30,000
S= EAT/ (Ke) = 30,000/ 12.5% = Rs. 2,40,000
V = S+B = 2,40,000+ 2,00,000= Rs.4,40,000

Dr. Bhagyashree Kunte 11

Unit II: Net Income Approach
Qu.3) Assuming no taxes and given the earnings before interest
and taxes (EBIT), interest (I) at 10% and equity capitalisation
rate (Ke) below, calculate the total market value of each firm
under Net Income Approach:
Firms EBIT I Ke

X 2,00,000 20,000 12.0%

Y 3,00,000 60,000 16.0%
Z 5,00,000 2,00,000 15.0%
Also determine the weight average cost of capital for each
firm.

Dr. Bhagyashree Kunte 12

Unit II: Net Income Approach
Solution 3: Calculation of valuation of each firm under Net
Income Approach :
Value of firm = Value of equity + Value of debt
Firm X (Rs.) Y(Rs.) Z(RS.)
EBIT 2,00,000 3,00,000 5,00,000
LESS: INTEREST @10% 20,000 60,000 2,00,000
EQUITY EARNINGS 180,000 2,40,000 3,00,000
COST OF EQUITY (Ke) 12% 16% 15%
CAPITALIZED VALUE 15,00,000 15,00,000 20,00,000
OF EQUITY
ADD: MV OF DEBT 2,00,000 6,00,000 20,00,000
VALUE OF FIRM 17,00,000 21,00,000 40,00,000
WACC (Ko) 11.76% 14.19% 12.50%

Dr. Bhagyashree Kunte 13

 Unit II: Net Income Approach
Equity 500,000 @ 15%
Debt = 500,000 @ 12%
Reserves = 5,00,000 @ 15%
Capital Value Weight Rate WACC
Equity 5,00,000 1/3 15 5
Debt 5,00,000 1/3 12 4
Reserves 5,00,000 1/3 15 5
Total 15,00,000 WACC 14

Dr. Bhagyashree Kunte 14

 Unit II: Net Income Approach
Equity 500,000 @ 18% Reserves =5,00,000 @ 18%,
Debt = 600,000 @ 12% (before tax) after Tax rate = Int rate* (1-t)
Preference shares 4 lakhs @ 15% tax @40% 12*(1-.4)
Capital Value Weight % Post tax WACC
Rate

Equity 5,00,000 25% 18 4.5

Debt 6,00,000 30% 7.2 2.16
Reserves 5,00,000 25% 18 4.5
Preference 4,00,000 20% 15 3
Total 20,00,000 14.16

Dr. Bhagyashree Kunte 15

 Unit II: Net Income Approach
Equity 10,00,000 @ 15%
Bank loan 5,00,000 @12%
Debentures: 5,00,000 @ 10%
Component Value Cost Weight WCC

Equity 10,00,000 15% 0.5 7.5

Loan 5,00,000 12% .25 3.0

Debentures 5,00,000 10% .25 2.5

Total 20,00,000 WACC 13

Dr. Bhagyashree Kunte 16

Unit II: Net Income Approach

End of 2: Net Income Approach

Dr. Bhagyashree Kunte 17