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NPP

BRILLIANT’S Capital Structure Theories 339

cost of capital will decline and the value of the H¡${nQ>b H$s ^m[aV H$m°ñQ> KQ>oJr Ed§ \$_© H$s d¡ë`y ~‹T>oJrŸ&
firm will increase. On the other hand, if the lever-
BgHo$ {dnarV `{X brdaoO KQ>m`m OmVm h¡ Vmo H¡${nQ>b H$s
age is decreased, the cost of capital will increase
H$m°ñQ> ~‹T>oJr VWm \$_© H$s d¡ë`y KQ>oJrŸ& ZoQ> BÝH$‘ H$s
and the overall value of the firm will reduce. The
essence of the Net Income (NI) approach is that AdYmaUm H$m gma `h h¡ {H$ H$moB© H$ånZr AnZo H¡${nQ>b
the firm can increase its value or decrease cost of
ñQ´>ŠMa _| F$U Ho$ AZwnmV _| n[adV©Z H$aHo$ \$_© H$s Hw$b
capital by increasing the proportion of debt in
d¡ë`y H$mo à^m{dV H$a gH$Vr h¡Ÿ&
the capital structure.
Assumptions _mÝ`VmE§
The NI approach is based on the following ZoQ> BÝH$‘ H$s AdYmaUm {ZåZ{b{IV _mÝ`VmAm| na
assumptions: AmYm[aV h¡…
(i) There are no taxes. (i) H$a H$mo Ü`mZ _| Zht aIm OmVmŸ&
(ii) The cost of debt is less than cost of equity. (ii) S>oãQ> H$s H$m°ñQ>, B{ŠdQ>r H$s H$m°ñQ> go H$_ h¡Ÿ&
(iii) The use of debt does not change the risk (iii) S>oãQ> Ho$ Cn`moJ go BÝdoñQ>g© H$s [añH$ na H$moB© à^md
perception of investors. Zht n‹S>Vm h¡Ÿ&

(iv) The debt capitalization rate (K ) is less (iv) S>oãQ> H¡${nQ>bmBOoeZ H$s Xa (K ) Bp³dQ>r H¡${nQ>bm-
d d
than the equity capitalization rate (K ) i.e. BOoeZ H$s Xa (K ) go H$_ h¡ AWm©V²Ÿ (K < K ) &
c c d e
(K < K )
d e
(v) The debt capitalization rate (K ) and (v) brdaoO _| n[adV©Z Ho$ ~mX ^r S>oãQ >H¡${nQ>cmBOoeZ
d
equity capitalization rate (K ) remain aoQ> (K ) Ed§ B{ŠdQ>r H¡${nQ>cmBOoeZ aoQ> (K ) pñWa
e d e
constant with changes in leverage. ahVr h¢Ÿ&
Example: Assume that a firm is expected CXmhaU… ‘mZm {H$ EH$ g§ñWm go < 20,00,000 ZoQ>
to generate net operating earnings of ` 20,00,000 Am°naoqQ>J A{Zª½g CËnÝZ H$aZo H$s Anojm H$s JB© h¡ {Ogo
which market capitalizes at the rate K , at 0.20
e ‘mH}$Q> 0.20 ¶m 20 à{VeV na aoQ> K na H¡${nQ>bmBO
or 20 percent. Assume that, it has ` 25,00,000 e
H$aVm h¡& ‘mZm {H$ BgHo$ nmg 16 à{VeV ã¶mO na S>oãQ> ‘|
in debt at 16 percent interest, given this
information, the value of the firm may be < 25,00,000 h¢, Bg Xr J¶r gyMZm go g§ñWm H$s d¡ë¶y
calculated as shown below: H$s {ZåZ àH$ma go JUZm H$s Om gH$Vr h¡&

Net operating earnings (in ` ) 20,00,000
Less: Interest on debt 4,00,000
Earnings available to equity shareholders [NI] 16,00,000
Assumed equity capitalization (K ) 0.20
e
Market value of equity (S) [NI ÷ K ] 80,00,000
e
Add: Market value of debt (B) 25,00,000
Total value of firm (v) 1,05,00,000

The implied over all capitalization rate is:
O 20,00,000
K    19.05 %
o
V 1,05,00,000