David Durant gave the theory of Net Income. According to this approach, the value of a company is affected by its capital structure and cost of capital.
According to this approach, the increase in the proportion of debt capital in the capital structure brings a decrease in overall cost of capital because debt is a cheaper Source of finance. The decrease in cost of capital, in turn, increases the value of the firm.
Thus, when the proportion of debt is 100% in capital structure, cost of capital is minimum. And when there is no debt in capital structure, the cost of capital is maximum.
Along with the basic assumptions of Capital Structure Theories, these assumptions specifically apply to Net Income Approach. I have mentioned the basic assumptions of Capital Structure Theories in the previous Post.
- There are no taxes.
- There are only two sources of finance i.e. debt and equity.
- Cost of debt is less than cost of equity.
- The increase in proportion of debt capital in the capital structure do not affect the risk perception of equity shareholders.