TRADITIONAL THEORY OF CAPITAL STRUCTURE

It is also known as intermediate approach, is a compromise between the two extremes of net
income approach and net operating income approach. It states that when the Weighted Average
Cost of Capital (WACC) is minimized, and the market value of assets is maximized, an optimal
structure of capital exists. This is achieved by utilizing a mix of both equity and debt capital.
This point occurs where the marginal cost of debt and the marginal cost of equity are equated,
and any other mix of debt and equity financing where the two are not equated allows an
opportunity to increase firm value by increasing or decreasing the firm’s leverage.
According to this theory, the value of the firm can be increased initially or the cost of capital can
be decreased by using more debt as the debt is a cheaper source of funds than equity.
Beyond a particular point, the cost of equity increases because increased debt increases the
financial risk of equity shareholders. The advantage of cheaper debt at this point of capital
structure is offset by increased cost of equity.
After this there comes a stag, when the increased cost of equity cannot be offset by the advantage
of low-cost debt. Thus, overall cost of capital, according to this approach, decreases up to a
certain point, remains more or less unchanged and increases or rises beyond a certain period.

ASSUMPTIONS
The Traditional Theory of Capital Structure says that for any company or investment there is an
optimal mix of debt and equity financing that minimizes the WACC and maximizes value.
Under this theory, the optimal capital structure occurs where the marginal cost of debt is equal to
the marginal cost of equity.
This theory depends on assumptions that imply that the cost of either debt or equity financing
vary with respect to the degree of leverage.
Cost of debt (kd) remains stable with an increase in the debt ratio to a certain limit after which it
begins to grow.
Cost of equity (ke) remains stable or grows slightly with an increase in the debt ratio to a certain
limit after which it begins to grow rapidly.
Weighted average cost of capital decreases to some degree with an increase in the debt ratio and
then begins to grow.
Cost of equity is larger than the cost of debt at any capital structure, i.e., ke>kd at any value of
debt ratio.
The traditional approach to capital structure believes the existence of optimal capital structure. It
is such a mix of debt and equity at which WACC reaches the minimal value and the value of a
firm will be maximized.
Graphs
Assumptions of the traditional approach to capital structure are illustrated in the figure below.

financial leverage is measured as a debt ratio

When financial leverage equals to 0, i.e., the capital of a firm is represented by equity only, its
WACC is equal to the cost of equity. As the financial leverage increases, the WACC will
decrease until the marginal cost of debt is lower than the marginal cost of equity. The minimal
value of WACC is reached when the marginal cost of debt equals the marginal cost of equity.
Such a capital structure is considered as optimal under the traditional approach. A further
increase of financial leverage will result in an increase of WACC as far as the marginal cost of
debt will be higher than the marginal cost of equity due to higher risks.
When the optimal capital structure is reached, the value of a firm is maximized as shown in the
figure below.

Understanding the Traditional Theory of Capital Structure

The Traditional Theory of Capital Structure says that a firm's value increases to a certain level of
debt capital, after which it tends to remain constant and eventually begins to decrease if there is
too much borrowing. This decrease in value after the debt tipping point happens because of
overleveraging. On the other hand, a company with zero leverage will have a WACC equal to its
cost of equity financing and can reduce its WACC by adding debt up to the point where the
marginal cost of debt equals the marginal cost of equity financing. In essence, the firm faces a
trade-off between the value of increased leverage against the increasing costs of debt as
borrowing costs rise to offset the increase value. Beyond this point, any additional debt will
cause the market value and to increase the cost of capital. A blend of equity and debt financing
can lead to a firm's optimal capital structure.

The Traditional Theory of Capital structure tells us that wealth is not just created through
investments in assets that yield a positive return on investment; purchasing those assets with an
optimal blend of equity and debt is just as important. Several assumptions are at work when this
theory is employed, which together imply that the cost of capital depends upon the degree of
leverage. For example, there are only debt and equity financing available for the firm, the firm
pays all of its earnings as a dividend, the firm's total assets and revenues are fixed and do not
change, the firm's financing is fixed and does not change, investors behave rationally, and there
are no taxes. Based on this list of assumptions, it is probably easy to see why there are several
critics.

The traditional theory can be contrasted with the Modigliani and Miller (MM) theory, which
argues that if financial markets are efficient, then debt and equity finance will be essentially
interchangeable and that other forces will indicate the optimal capital structure of a firm, such as
corporate tax rates and tax deductibility of interest payments.
How it works
The theory can be demonstrated on a diagram in which:
Ke = Cost of Equity
Kd = Cost of Debt
Ko = Overall Cost of Capital or Weighted Average Cost of Capital

K is a point where an optimal capital structure exists and according to the theory at this point, the
company will have maximum market value.
REFERRENCE
1. https://www.researchgate.net/figure/Capital-Structure-Theories-Traditional-Approach
2. https://www.investopedia.com/terms/t/traditionalcapitalstructure.asp
3. https://efinancemanagement.com/financial-leverage/capital-structure-theory-traditional-
approach
4. Myers, S.C. (2001). Capital Structure. The Journal of Economic Perspectives. 15(2), 81-
102.