NET INCOME APPROACH - Accounts and Finance for Managers

Algebraically, the relationship between the cost of equity, cost of overall capital and debt-equity ration are explained as follows:
Ke=Ko+ (Ko–Ki)B/S

Net Income Approach Problems

Net income approach was developed by Durand, in this he has portrayed the influence of the leverage on the value of the firm, which means that the value of the firm is subject to the application of debt i.e., leverage.

In this approach, the cost of debt is identified as cheaper source of financing than equity share capital. The more application of debt in the capital structure brings down the overall capital, more particularly 100% application of debt finance leads to resemble the over all cost of capital as cost of debt. The weighted average cost of capital will come down due to more application of leverage in the capital structure, only with reference to cheaper cost of raising than the equity share capital cost.
Ko= Ke(S/V)+Ki(B/V)
The value of the firm is more in the case of lesser overall cost of capital due to more application of leverage in the capital structure. The optimum capital structure is that at when the value of the firm is highest and the overall cost of capital is lowest.
V=B+S
V= EBIT/Ko
This approach highlights that the application of leverage influences the overall cost of capital and that affects the value of the firm.


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