Q. Describes Net Income Approach to Capital Structure?
Net Income Approach: - As-per to the Net Income Approach as suggested by Durand the capital structure decision is applicable for the valuation of the firm. Alternatively a change in the financial leverage (the ratio of debt to equity) will lead to a corresponding change in the value of the firm and the overall cost of capital.
As-per to this approach:
(i) If the ratio of debt to equity is raise the cost of capital will decline while the value of the firm and the market price of equity shares will increase.
(ii) A diminish in the ratio of debt to equity will cause an increase in the overall cost of capital and a decline both in the value of the firm and the market price of equity shares.
Therefore a firm can minimize the cost of capital and increase the value of the firm and market price of its equity shares by using debt financing to the maximum possible extent.
Assumptions: - Net Income Approach is on the basis of the following assumptions:
(i) The cost of debt is lesser than the cost of equity.
(ii) There are no corporate or else personal income taxes.
(iii) Use of debt doesn't change the risk perception of investors.