Net Income (NI) Approach
When there is a change in capital structure, there takes place a change in overall cost of capital and to a very great extent in total value of firm. To be more accurate manner, if financial leverage is increased by raising the proportion of debts to equity there will be a step-down in weighted average cost of capital and an increase in the market value of its shares. In converse manner, if financial leverage is reduced by lowering the ratio of debts to equity, there will be an increase in weighted average cost of capital and a fall in the market value of its shares.
Certain assumptions are mentioned below:
There are no taxes on corporates.
The cost of equity is greater than cost of debt.
The employ of debt content does not change at risk perception of investors as a outcome both the kd (debt capitalization rate) and kc (equity-capitalization rate) remains fixed.
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