The traditional approach to capital structure implies that an optimum debt-to-equity level

occurs when the gross cost of capital is the lowest and the company's market price the
highest Alterations in the financing balance on either hand will affect the value of the
company in a positive way. The net borrowing rates before and after this stage were smaller
than capital costs.

Debt is (usually) cheaper than equity

 Lower risk.
 Tax relief on interest.

so we might expect that increasing proportion of debt finance would be a good idea and
would reduce WACC.

BUT:

Second, increasing levels of debt makes equity riskier:

 Fixed commitment paid before equity = finance risk.

It increases the cost of investment and would raise the WACC, as higher gearing (proportion
of funding in the form of debt).

The theories attempt to answer the question:

The traditional theory of gearing

The traditional view, also known as the intuitive view, is not based on theory but on common
sense. This implies that an organization should have the optimum gear rate, but that does not
know where the WACC is reduced. Testing and failure are the only way to find the optimal
stage.

The traditional view explained

At low levels of gearing:

Equity holders find threats to be overlooked as gear rises, so the debt problem's cheapness is
driven by a lower WACC.

At higher levels of gearing:

Equity holders become increasingly concerned with the increased volatility of their returns
(debt interest paid first). This dominates the cheapness of the extra debt so the WACC starts
to rise as gearing increases.

At very high levels of gearing:

Serious default threats scare equity and debt owners, so that the WACC is further increasing,
both Ke and Kd.

This can be shown diagrammatically:

where:

Ke is the cost of equity

Kd is the cost of debt, and

Ko is the overall or weighted average cost of capital.

The traditional approach to the management of finance encourages the right blend of the
capital structure of debt and equity to increase a company's market price. In the capital
structure, debts should only exist to a certain extent in line with this approach and any
leverage increase would lead to a decrease in the company's value.
This means that the debt-to-equity level occurs optimally and the WACC is the lowest and the
company's market price is the largest. When the corporation reaches the maximum debt-to-
equity rate, capital costs increase to impair the WACC.
The above graph depicts the following:

 Cheap debt finance is rapidly being used at low prices, driving WACC down.
 High gear drives up the WACC and rapidly increasing equity costs are dominant.
 There is an ideal capital structure, which minimizes WACC and maximizes the value of
the company.