Capital Structure Theory - Traditional Approach

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Traditional approach to capital structure suggests that
there exist an optimal debt to equity ratio where the overall cost of capital is the minimum and market
value of the firm is the maximum. On either side of this point, changes in the financing mix can bring
positive change to the value of the firm. Before this point, the marginal cost of debt is less than cost of
equity and after this point vice-versa.
Capital Structure Theories and its different approaches put forth the relation between the proportion of
debt in financing of a company's assets, the weighted average cost of capital (WACC) and the market
value of the company. While Net Income Approach and Net Operating Income Approach are the two
extremes Approach are the two extremes, traditional approach, advocated by Ezta Solomon and Fred
Weston is a midway approach also known as intermediate approach.
Traditional Approach to Capital Structure:
Traditional approach to capital structure advocates that there is a right combination of equity and debt in
the capital structure, at which the market value of a firm is maximum. As per this approach, debt should
exist in the capital structure only up to a specific point, beyond which, any increase in leverage would
result in reduction in value of the firm.
It means that there exists an optimum value of debt to equity ratio at which the WACC is the lowest and
the market value of the firm is the highest. Once the firm crosses that optimum value of debt to equity
ratio, the cost of equity rises to give a detrimental effect to the WACC. Above the threshold, the WACC
increases and market value of the firm starts a downward movement.
Assumptions under Traditional Approach:
1. The rate of interest on debt remains constant for a certain period and thereafter with increase in
leverage, it increases.
2. The expected rate by equity shareholders remains constant or increase gradually. After that the
equity shareholders starts perceiving a financial risk and then from the optimal point and the
expected rate increases speedily.
3. As a result of activity of rate of interest and expected rate of return, the WACC first decreases
and then increases. The lowest point on the curve is optimal capital structure.
Diagrammatic Representation of Traditional Approach to Capital Structure:

Example Explaining Traditional Approach:
Consider a fictitious company with the following data.
Proportion of debt = 20%
Proportion of equity = 80%
Cost of debt = 10%
Cost of equity = 13%
WACC = (Weight of Debt X Cost of Debt) + (Weight of Equity X Cost of Equity)
= (20% x 10%) + (80% x 13%)
= 2 + 10.4
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= 12.4%
Now, assume the company increases its financial leverage and as a result, the debt is 30% and equity is
70%. The cost of debt and equity also rise because of the company's higher exposure to risk. The new
WACC is calculated as follows.
Proportion of debt = 30%
Proportion of equity = 70%
Cost of debt = 11%
Cost of equity = 14%
WACC = (Weight of Debt X Cost of Debt) + (Weight of Equity X Cost of Equity)
= (30% x 11%) + (70% x 14%)
= 3.3 + 8.4
= 11.9%
As observed, with the increase in the financial leverage of the company, the overall cost of capital
reduces, despite the individual increases in the cost of debt and equity respectively. The reason being
that debt is a cheaper source of finance.
Now, assume the company increases its financial leverage further and as a result, the debt is 50% and
equity is 50%. The cost of debt and equity rise further. The new WACC is calculated as follows.
Proportion of debt = 50%
Proportion of equity = 50%
Cost of debt = 12%
Cost of equity = 15%
WACC = (Weight of Debt X Cost of Debt) + (Weight of Equity X Cost of Equity)
= (50% x 12%) + (50% x 15%)
= 6 + 7.5
= 13.5%
As observed, with the increase in the financial leverage of the company to the current levels, the over
cost of capital increases.
The above exercise shows that increasing the debt reduces WACC, but only to a certain level. After that
level is crossed, a further increase in the debt level increases WACC and reduces the market value of the
company.