Capital structure plays an important role in value of a company. Different companies have different capital structures like some have capital based on debt, some have based on equity and some have a mixed or combination of both in their financial mix.
Durand proposed net income approach and he states that change in cost of capital and valuation of company will change, if there a change in financial leverage. Capital structure is relevant to valuation of a firm. Increase in financial leverage leads to increase in weighted average cost of capital (WACC) and value of firm will increase.
Market value of equity shares depends on amount available after paying interest on debt. This approach prepositions that market value depends on the amount available for equity shareholders. Net income and cost of capital depends on use of Debt in capital structure, which had an impact on equity shares and market value.
NI = NOI – I
Where, NI = net income, NOI = net operating income and I = interest on debt.
Assumptions related to net income are as follows −
Cost of equity > cost of debt.
Both debt and equity capitalisations are constant.
Debt proportion is independent of investors risk.
Dividend pay-out ratio is 1.
V = E + D
Where, V = market value (firm), E = market value (Equity) + Market value (Debt)
E = equity shareholder’s income/ cost of equity
D = interest rate on debt/ cost of Debt
Cost of capital = NOI/V Degree of financial leverage = D/V
Where, NOI = Net operating income.
Disadvantages of net income are as follows −
Corporate taxes are not considered.
It has constant cost of debt (interest rate depends on fund providers).
Financial risk increases with increase debt.
Financial leverage increases with increase in equity capitalisation.