Net Income

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a. Differentiate NI Approach and NOI Approach in capital structure decisions.

Net Income (NI) Approach
The Net Income Approach to the relationship between leverage cost of capital and value of the firm. It suggest that there is relationship between capital structure and the value of the firm and therefore, the firm can affect its value by increasing or decreasing the debt proportion in the overall financing mix.

Assumptions of NI Approach
1. The total capital requirements of the firm are given and remain constant.
2. Cost of debt is less than cost of capital.
3. Both cost of debt and cost capital remain constant and increase in financial leverage i.e., use of more and more debt financing in the capital structure does affect the risk perception of the investors.

The figure shows that the Ke and Kd are constant for all levels of leverages i.e., for all levels of debt financing. As the debt proportion or the financial leverage increases, the WACC decreases as the cost of debt is less than cost of equity. This result in the increase in value of the firm. In the figur...

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