2.3.1 Theory of Net Income (NI)The theory of net income states that there prevails a connection between firm’ s value and capital structure. A company’ s capital structure influences its WACC and therefore directly has an impact on the firm’ s value. The assumptions of net income approach are: • It believes that an incessant augmentation in debt generally does not impact the investors’ risk perception. • Cost/price of equity is more than the debt’ s cost. • The tax on the corporate income does not exist. As per this approach, more utilisation of the debt capital causes lessening of WACC.
This results in the increased value of the company. When the WACC is decreased and EBIT remains constant, then the worth of company always increase. Therefore, this approach states that a company will have utmost value when WACC will be at its minimum i. e. at the time when the company is nearly debt-financed. If the theory is valid, then the average is considered as an important variable and the financing decisions will also have the considerable effect on firm’ s valuation (Booth et al, 2001). 2.3.2 Theory of Net Operating Income (NOI)This approach is just reverse of the NI approach.
As per this theory, a firm’ s value does not depend on its structure of the capital. The utilisation of more amounts of borrowings i. e. the debt element in capital structure generally augments the threat to the shareholders (Casamatta, 2003). Augmentation in the risk of the shareholders leads to the increase in the rate of equity capitalisation, which means higher equity cost. The greater equity cost nullifies the benefits achieved due to inexpensive debt cost. It means that finance mix is immaterial and do not have an effect on the company’ s value (Casamatta, 2003).
Assumptions of this theory are: • WACC always remains stable and it relies on business risk. • The value of the company is estimated using WACC only. • Cost/price of debt also remains stable. • The tax on the corporate income does not exist.
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