What is the traditional approach of capital structure? What is the net income approach of capital structure.

Traditional approach of capital structure

The NI technique and the NOI approach represent two polar instances. The conventional, or intermediate, method is a midway point between these two techniques since it partly adopts the elements of both systems. The traditional approach of capital structure refers to the way a company finances its operations through a mix of debt and equity.


According to the idea, the value of the business may be boosted or the cost of capital decreased by a sensible mix of debt and equity capital. This method says that the cost of capital is a function of leverage. So the cost of capital falls up to a certain degree of leverage, then continues at the same level for a certain degree of leverage, and thereafter it rises quickly with the leverage. So optimum capital structure exists when the cost of capital is minimal or the value of the enterprise is the highest.

The method by which the cost of capital reacts to changes in the capital structure may be separated into three stages.

1. In the first stage, the cost of equity remains constant or rises slightly with the debt. But when it grows, it does not increase quickly enough to negate the advantage of low-cost loans. The cost of debt also remains the same or rises somewhat with leverage. As the cost of debt is less than the cost of equity, higher usage of debt decreases the overall cost of capital during the first stage.

2. Once the business has achieved a given degree of leverage, greater use of debt does not result in a decline in the overall cost of capital. This is due to the fact that the benefits of low-cost financing are outweighed by the increase in the cost of equity. Within this range, the cost of capital will be the smallest, and the value of the enterprise will be the largest.

3. Beyond a certain point, the use of debt has a detrimental effect on the cost of capital and the value of the business. This arises because the business would become more hazardous to the investors, who would penalize the enterprise by seeking a larger return. The advantages of adopting a low-cost loan are fewer than the downsides of higher-cost equity. So the overall cost of capital grows with leverage, and the value of the enterprise declines.

Thus, the overall cost of capital falls with leverage until it reaches a minimal threshold and then increases with leverage. The link between the cost of capital and leverage is depicted in the following graph:

Traditional-approach-of-capital structure
traditional-approach-to-capital-structure
traditional-approach-of-capital-structure example

Net income approach of capital structure

This strategy was suggested by David Durand. According to this method, the capital structure decision is crucial to the value of the business. According to the idea, it is feasible to adjust the cost of capital by changing the debt-equity mix. In other words, a change in the capital structure produces a change in the total cost of capital as well as the value of the business.

The NI method is based on the following assumptions:

  • The use of debt does not modify the risk of investors, and hence the cost of debt (Kd) and the cost of equity (Ke) stay the same irrespective of the degree of leverage.
  • The cost of debt is less than the cost of equity.
  • The corporate income tax does not exist.


According to the idea, the cost of debt is believed to be less than the cost of equity. Therefore, when the financial leverage is increased (the share of debt in the total capital), the overall cost of capital will fall and the value of the business will grow. The consequences of the three assumptions of the NI method are that when the degree of leverage grows, the share of a cheaper source of funds (debt) in the capital structure increases. As a result, the weighted average cost of Capital tends to diminish, resulting in a rise in the overall worth of the company.

Thus, even if the cost of debt and equity stay the same regardless of leverage,increased usage of low-cost debt will result in a drop in the total cost of capital and thereby enhance the value of the organization. So the overall cost of capital will be the lowest when the share of debt in the capital structure is the largest. So an ideal capital structure arises when the corporation utilizes 100% debt or maximum debt in its capital structure.


The NI method may be compared to a dishonest seller who tries to sell 10 liters of milk at Rs. 15 per liter. He can add water and pure milk to create 10 liters of milk. If the cost of 1 liter of water is Rs. 1, and the cost of 1 liter of pure milk is Rs. 10, he may maximize his profit or decrease his expense per liter of milk by adding more and more of the low-priced water. For example, if he purchases solely pure milk, his cost will be Rs. 10* 10 = Rs. 100. If he adds 5 liters of water to 5 liters of milk, the

The cost of 10 liters would be 1*5+10*5 = Rs. 55 (Rs. 5.5/liter). Here, pure milk is compared to equity, which is a pricey source, while water is compared to debt, which is a cheaper supply.

Example: A company’s estimated net operating income (EBIT) is Rs. 1,00,000. The firm has issued Rs. 5,00,000 in 10% debentures of Rs. 100 apiece. The cost of equity is 12.5%. Assuming no taxes, find out the overall cost of capital and the value of the enterprise according to the NI method.

Net-income-approach-of-capital-structure
explain-the-net-income-approach-to-capital-structure

With leverage, we discover that both curves are horizontal to the X-axis. But when the degree of leverage grows (the percentage of debt in the total capital increases), the overall cost of capital constantly declines. Ko is highest when there is zero debt, and it is minimal when there is 100% debt. So the best capital structure exists at 100% debt and 0% equity capital. But in actuality, 100% debt may not be attainable. There should be some equity capital in the capital structure of each corporation.

Leave a comment