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Net Income Approach of Valuing a Firm
The theory of the net income approach suggests increasing the value of a firm by decreasing the overall cost of capital. The cost of capital in the theory is measured in terms of Weighted Average Cost of Capital (WACC). It can be done by incurring and collecting a higher proportion of debt because it is a cheaper source of finance in comparison to equity finance.
WACC is the weighted average costs of equity and debts, and the weights are the units of capital collected from each source.
According to the Net Income Approach theory, changes in the financial leverage of a firm leads to a corresponding change in the WACC and also the value of the company. The Net Income Approach stresses on the fact that −
With the increase in financial leverage (or the proportion of debt), the WACC decreases, and the value of the firm increases.
Alternately, if there is a decrease in the leverage, the WACC will increase, and thereby the value of the firm will decrease.
For example, if the equity-debt mix changes to 30:70 from 50:50, it will have a positive impact on the shareholders’ value of the business.
Assumptions of Net Income Approach
Net Income Approach makes certain assumptions which are as follows −
The diminishing debt will not let the confidence levels of the investors come down.
Only two sources of finance are considered in the theory, which are debt and equity. Other sources of finance like Retained Earnings and Preference Share Capital are considered.
All companies must have a uniform dividend payout ratio, which is 1.
There are no costs such as flotation cost, no transaction cost, and corporate dividend tax.
The capital market is operating perfectly, which means information about all the relevant companies is available to all the investors. There are no opportunities for overpricing or underpricing of security. Further, it assumes that all the investors are rational who want to maximize their return with minimization of risks.
All sources of funds are perpetuity, which means the finance is for infinity. Moreover, there are no redeemable sources of finance.
Generally, in case of the Net Income Approach, with an increase in debt, the total market value of the company increases, while the cost of capital decreases. The reason for this conclusion is due to the assumption of the Net Income approach that irrespective of debt financing in capital structuring, the cost of equity will remain constant. Moreover, the cost of debt stays lower than the cost of equity; so when the debt finance is increased, WACC reduces, thereby increasing the value of the firm.
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