Q. Show the Graphic Presentation of Net Income Approach?

Graphic Presentation of Net Income Approach: - Net Income approach is described graphically as follows:

In the given figure the degree of leverage is plotted along the X-axis while the percentage rate of cost of capital is shown on Y-axis. The figure shows that K_e in addition to K_d remain unchanged. However as the degree of leverage increases cost of capital K_o decreases. K_o however cannot touch K_o as there cannot be all debt firm. The best possible capital structure is one at which K_d is nearest to K_d. At this level the firm's whole cost of capital would be lowest and the market value of the firm and market value per share is highest.

Basic Terms:-

EBIT = Earnings before Interest and Tax                              S = Value of Equity

B = Value of Debt                                                                  V = Value of firm

NI = Net Income                                                                    K_d = Cost of Debt

K_o = Overall Cost of Capital                                                  K_e = Cost of Equity

Basic Formulas:-

V = S + B                                                        NI = EBIT - Interest

K_o = EBIT / V                                                      S =   NI / K_e