To explain the relationship among capital structure, cost of capital and value of the firm various theories have been propounded by different authors. Concept: The Net Income (NI) approach was propounded by David Durand.
There are four major theories which present differing views on the relationship between use of financial leverage and common stock value. According to him the decision relating to capital structure has an impact on the valuation of the firm.
Since this cost increase is due to increase in debt it is known as implicit cost of debt.
The advantage of using debt being a cheaper source is neutralized by the increased cost of equity.
The traditional theorists believe that, up to certain point a firm can reduce cost of capital and raise market value of the stock by increasing the proportion of debt in its capital structure. According to this approach, cost of capital is not independent of the capital structure of the firm.
It states that up to a certain point increase in leverage causes overall cost of capital to decline but after attaining the optimum level, increase in leverage will increase the overall cost of capital.
We know: Overall cost of capital = EBIT /value of firm or K = EBIT /V Net income approach can also be explained graphically.
In Figure 6.1 we have measured financial leverage on the horizontal axis and cost of capital on the vertical axis.
So it is also known as the Intermediate or Midway Approach.
According to this theory the value of the firm can be increased or the cost of capital can be decreased initially by using more debt, as the debt is a cheaper source of funds than equity.