Theories of Capital Structure

Net Income Approach:-

The essence of net income approach is that the firm can increase its value or lower the overall cost of capital by increasing proportion of debt in capital structure.

The assumption of this approach are:-

1) The use of debt does not change the risk perception of investors, as a result equity capitalisation rate (kc) & debt-capitalisation rate (kd) remain constant with changes in leverage.

2) The debt capitalisation rate is less than equity-capitalisation rate (i.e. kd <>

3) The corporate income taxes do not exist.

The first assumption implies that if ke & kd are constant, increased use of debt by magnifying the shareholders earnings, will result in higher value of the firm via higher value of equity. Consequently, overall or weighted average cost of capital, ko will decrease. The overall cost of capital is measured by Eq-


Ko= _X__ =__Noi_

V V

Thus, with constant annual net operating income (NOI) overall cost of capital of capital would decrease as the value of firm, V increases.