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Net Income Approach: Presented By:Neethu.G

This document discusses the net income approach for calculating a company's value. It defines net income as revenues minus all costs for a company or gross income minus taxes and deductions for an individual. The net income approach assumes the cost of equity and debt remain unchanged as a company takes on more debt. It concludes the weighted average cost of capital declines as debt increases due to debt having a lower cost than equity. Two examples are provided to demonstrate how to calculate a company's value using the net income approach based on its operating income, interest expenses, costs of equity and debt, and market values.

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Neethu Binoy
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149 views13 pages

Net Income Approach: Presented By:Neethu.G

This document discusses the net income approach for calculating a company's value. It defines net income as revenues minus all costs for a company or gross income minus taxes and deductions for an individual. The net income approach assumes the cost of equity and debt remain unchanged as a company takes on more debt. It concludes the weighted average cost of capital declines as debt increases due to debt having a lower cost than equity. Two examples are provided to demonstrate how to calculate a company's value using the net income approach based on its operating income, interest expenses, costs of equity and debt, and market values.

Uploaded by

Neethu Binoy
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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NET INCOME APPROACH

PRESENTED BY:NEETHU.G
DEFINITIONS
• In business, what remains after subtracting all
the costs (namely, business, depreciation,
interest, and taxes) from a company's
revenues. Net income is sometimes called
the bottom line. also called earnings or net
profit.
• For an individual, gross income minus taxes,
allowances, and deductions. An individual's
net income is used to determine how much
income tax is owed.
 
ASSUMPTION
• The net income approach
makes the simplest
assumptions, that neither
creditors nor investors increase
their required rates of return as
a company takes on debt. The
cost of capital declines as
higher-cost equity is replaced
with lower-cost debt. This
approach concludes that the
• According to this approach, the cost of equity
capital, i.e., ke and the cost of debt, kd remain
• unchanged when B/S, the degree of leverage
varies. This means that ko, the average cost of
capital
• measured as ko = kd{B/(B+S)} + ke{S/(B+S)}
declines as B/S increases. This happens
because when
• B/S increases, kd, which is lower than ke,
receives higher weight in the calculation of ko.
According to this approach, the cost of equity
capital, i.e., ke and the cost of debt, kd
remain
unchanged when B/S, the degree of leverage
varies. This means that ko, the average cost
of capital
measured as ko = kd{B/(B+S)} + ke{S/(B+S)}
declines as B/S increases. This happens
because when
B/S increases, kd, which is lower than ke,
receives higher weight in the calculation of
ko.
EXAMPLE 1
Suppose that a firm has no debt in its capital structure. It
has an expected annual net operating income of Rs
100,000 and the equity capitalization rate, ke, of 10%.
Since the firm is 100% equity financed firm, its weighted
cost of capital equals Its cost of equity ie, 10%.
The value of the firm will be : 100,000/0.10=Rs 1,00,0000
Let us assume that the firm is able to change its
capital structure replacing equity by debt of Rs 3,00,000.
The cost of debt is 5% .
Interest payable to debt holders is Rs3,00,000*0.05 = Rs
15,000.
The net income available to equity holders is Rs
1,00,000-Rs 15000 = Rs 850,000
The value of the firm is equal to the sum of values
of all securities:
E = NOI-interest/ke
= 85000/0.01 = 850000
D = interest/kd
= 15,000/0.05 = Rs 300000
V = E+D
= 850000+300000 = Rs 1,150,000
The weighted average cost of capital , k0, is;
k0 = NOI/V
= 100,000/115,000 = 0.087 or 8.7%
EXAMPLE 2
The value of shares (equity) , E, is the discounted
value of shareholder’s earnings , called net
income , NI . Firm’s L is net come is : NOI –
interest
= 1000-300 = Rs 700 ,
and the cost of equity is 9.33% hence the value of

L’s equity is 700/0.0933 = Rs 7500


E = net income/cost of equity
= NI/k0
= 700/0.0933 = Rs 7500
Similarly the value of a firm’s debt is the
discounted value of debt holders’ interest
income. The value of L’s debt is : 300/0.06
= Rs 5000
Value of debt = discounted value of interest
D = Interest/cost of debt
= int/kd
= 300/0.06
= Rs 5000
The value of firm = value of equity+value of
debt
V = E+D
= 75000+5000
= Rs 12,500
Firm’s cost of capital = net operating
income/value of the firm
k0 = NOI/V
= 1000/12,500
= 0.08 or 8%
The net income approach may be
illustrated with a numerical
example
• Consider two firms X and Y,
which are identical in all aspects
excepting in the degree of
leverage
employed by them. The following
is the financial data for these
Firm X FirmY
Net operating 2lacs 2lacs
income (O)
Interest on debt (F) ------- 50,000/-
Equity earnings (E) 2lacs 1.5lacs
Cost of equity 15% 15%
capital (ke)
Cost of debt capital 16% 16%
(kd)
Market value of 13.33lacs 10lacs
equity E/ke (S)
Market value of debt ------ 3.13lacs
(B)
Total value of firm 13.33lacs 13.13lacs
(V)
THANK YOU

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