## THE NET INCOME APPROACH (NI)

The essence of the NI approach is that the firm can increase its value or lower the overall cost of capital by increasing the proportion of debt in the capital structure. The crucial assumption of this approach are:

(a) The use of debt does not change the risk perception of the investor. Thus K_{d} and K_{e} remain constant with changes in leverage.

(b) The debt capitalization rate is less than equity capitalization rate (i.e. K_{d} < K_{e}).

The implications of these assumptions are that with constant K_{d} and K_{e}, increased use of debt, by magnifying the shareholders earnings will result in a higher value of the firm via higher value of equity. The overall cost of capital will therefore decrease. If we consider the equation for the overall cost of capital,

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K_{o} decreases as D/V increases because K_{e} and K_{d} are constant as per our assumptions and K_{d} is less than K_{e}. This also implies that K_{o} will be equal to K_{e} if the firm does not employ any debt (i.e. when D/V = 0) and that K_{o} will approach K_{d} as D/V approaches 1.