Net income approach and net operating income approach were proposed by David Durand. According to NI approach, there exists positive relationship between capital structure and valuation of firm and change in the pattern of capitalisation brings about corresponding change in the overall cost of capital and total value of the firm.
Thus, with an increase in the ratio of debt to equity overall cost of capital will decline and market price of equity stock as well as value of the firm will rise. The converse will hold true if ratio of debt to equity tends to decline.
This approach is based on three following assumptions:
(1) There are no taxes;
(2) Cost of debt is less than cost of equity;
(3) The use of debt does not change the risk perception of investors. This implies that there will be no change in cost of debt and cost of equity even if degree of financial leverages changes.
On the basis of the above assumptions, it has been held in the NI approach that increased use of debt will magnify the shareholders’ earnings (because cost of debt and cost of equity will remain constant) and thereby result in rise in share values of equity and so also value of the firm.
Thus, a firm can achieve optimal capital structure by making judicious use of debt and equity and attempt to maximise the market price of its stock.
Net Operating Income Approach (NOI):
According to Net Operating Income Approach which is just opposite to NI approach, the overall cost of capital and value of firm are independent of capital structure decision and change in degree of financial leverage does not bring about any change in value of firm and cost of capital.
The market value of the firm is determined by the following formula:
The crucial assumptions of the NOI approach are:
(1) The firm is evaluated as a whole by the market. Accordingly, overall capitalisation rate is used to calculate the value of the firm. The split of capitalisation between debt and equity is not significant.
(2) Overall capitalisation rate remains constant regardless of any change in degree of financial leverage.
(3) Use of debt as cheaper source of funds would increase the financial risk to shareholders who demand higher cost on their funds to compensate for the additional risk. Thus, the benefits of lower cost of debt are offset by the higher cost of equity.
(4) The cost of debt would stay constant.
(5) The firm does not pay income taxes.
Thus, under the NOI approach the total value of the firm as stated above is determined by dividing the net operating income (EBIT) by the overall capitalisation rate and market value of equity (S) can be found out by subtracting the market value of debt (B) from the overall value of the firm (V). In other words.
While the above two approaches represent extreme views about the impact of financial leverage on value of firm and cost of capital, traditional approach offers an intermediate view which is a compromise between the NOI and NI approaches.
This approach resembles the NI approach when it argues that the value of the firm can be increased and cost of capital can be reduced by the judicious mix of debt and equity share capital but it does not subscribe to the view of NI approach that the value of the firm will increase and cost of capital will decrease for all the degrees of financial leverage.
Further, the traditional approach differs from the NOI approach because it does not hold the view that the overall cost of capital will remain constant whatever be the degree of financial leverage. Traditional theorists believe that up to certain point a firm can by increasing proportion of debt in its capital structure reduce cost of capital and raise market value of the stock.
Beyond the point further induction of debt will lead the cost of capital to rise and market value of the stock to fall. Thus, through a judicious mix of debt and equity a firm can minimise overall cost of capital to maximise value of stock. They opine that optimal point in capital structure is one where overall cost of capital begins to rise faster than the increase in earnings per share as a result of application of additional debt.
Traditional view regarding optimal capital structure can be appreciated by categorizing the market reaction to leverage in following three stages:
The first stage starts with introduction of debt in the firm’s capital structure. As a result of the use of low cost debt the firm’s net income tends to rise; cost of equity capital (Ke) rises with addition of debt but the rate of increase will be less than the increase in net earnings rate. Cost of debt (Ki,) remains constant or rises only modestly. Combined effect of all these will be reflected in increase in market value of the firm and decline in overall cost of capital (K0).
In the second stage further application of debt will raise costs of debt and equity capital so sharply as to offset the gains in net income. Hence the total market value of the firm would remain unchanged.
After a critical turning point any further dose of debt to capital structure will prove fatal. The costs of both debt and equity rise as a result of the increasing riskiness of each resulting in an increase in overall cost of capital which will be faster than the rise in earnings from the introduction of additional debt. As a consequence of this market value of the firm will tend to depress.
The overall effect of these stages suggests that the capital structure decision has relevance to valuation of firm and cost of capital. Up to favorably affects the value of a firm. Beyond that point value of the firm will be adversely affected by use of debt.
The traditional view of optimal structure is set forth graphically in figure 14.3.
It may be noted from figure 14.3 that the cost of capital curve (Ke) is saucer shaped where an optimal range is extended over the range of leverage. But cost of capital curve need not always be saucer shaped. It is possible that stage 2 may not exist at all and instead of optimal range we may have optimal point in capital structure. This possibility is shown in figure 14.4.
Thus, cost of capital curve may be V shaped which yudecdes that applications of additional debt in capital structure beyond a point will result in an increase in total cost of capital and fall in market value of the firm. This is an optimal level of debt and equity mix which every firm must endeavour to attain.