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145 Pdfsam FM

The traditional approach proposes that there is an optimal capital structure which minimizes a firm's weighted average cost of capital. It suggests that the cost of debt remains constant up to a certain level of leverage but then rises sharply, while the cost of equity rises gradually up to a point and then sharply increases. The average cost of capital decreases with leverage up to an optimal point, then remains constant for moderate increases before rising beyond that point. This approach argues that the optimal structure equalizes the real marginal cost of debt and equity.

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30 views1 page

145 Pdfsam FM

The traditional approach proposes that there is an optimal capital structure which minimizes a firm's weighted average cost of capital. It suggests that the cost of debt remains constant up to a certain level of leverage but then rises sharply, while the cost of equity rises gradually up to a point and then sharply increases. The average cost of capital decreases with leverage up to an optimal point, then remains constant for moderate increases before rising beyond that point. This approach argues that the optimal structure equalizes the real marginal cost of debt and equity.

Uploaded by

dskrishna
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Traditional approach

The traditional view has emerged as a compromise to the extreme positions taken by the net income approach. According to this approach a judicious mix of debt capital and equity capital can increase the value of the firm by reducing the weighted average cost of capital up to a certain level of debt. Thus, the traditional approach proposes that The cost of debt capital remains more or less constant up to a certain level of leverage but thereafter rises very sharply at an increasing rate The cost of equity capital remains more or less constant or rises only gradually up to a certain degree of leverage and rises very sharply thereafter The average cost of capital, as a result of the above behaviour of cost of debt and cost of equity decreases up to a certain point, remains more or less unchanged for moderate increases in leverage thereafter and rises beyond a certain point This traditional approach is not very clearly or sharply defined as the net income or net operating income approaches. The main proposition of the traditional approach is that the cost of capital is dependent on the capital structure and there is an optimal capital structure which minimizes the cost of capital. At this optimal capital structure point the real marginal cost of debt and cost of equity will be the same. Before this optimal point, the real marginal cost of debt is less than the real marginal cost of equity and beyond the optimal point the real marginal cost of debt is more than the real marginal cost of equity The traditional approach implies that investors value leveraged companies more than the unlevered companies. This implies that they are prepared to pay a premium for the shares of such levered companies. The contention of the traditional approach that any addition of debt in sound companies does not really increase the riskiness of the business and the shares of the company is not defendable. Therefore there is no sufficient justification for the assumption

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