TRADITIONAL APPROACH

It is intermediate approach between the NI and

NOI approaches.

Management, Bangalore
Prof. Anand Patil, Alliance School of

It contains the features of both NI and NOI

According to this approach

“ The value of the firm (V) can be increased or cost of
capital(Ko) can be reduced by a judicious mix of debt
and equity”.

Management, Bangalore
Prof. Anand Patil, Alliance School of

Ko is the function of leverage: It means if the leverage
is increased ko will decrease and if the leverage is
decreased ko will increase.

This function of leverage(Ko fluctuation )has 3
different stages

Ko decreases up to a certain degrees of leverage.

Ko remains same for certain degrees of leverage

Ko increases sharply with certain degree of leverage

Optimum capital structure is where Ko is minimum

Management, Bangalore
Prof. Anand Patil, Alliance School of
and V is maximum

Capital structures
based on the cost of capital reaction to Capital structure
changes

1. Cost of equity remains constant or rises

Management, Bangalore
Prof. Anand Patil, Alliance School of
slightly with the debt:
cost of debt is less than cost of equity
more debt – lower cost of capital
equity cost remains same even if rises it will rise
sharply
2. Benefits of low cost debt is offset by increased
cost of equity:
After reaching certain degree of leverage the use of debt
becomes will not lead to fall in ko
Ko will be

Management, Bangalore
Prof. Anand Patil, Alliance School of
3. Beyond certain point use of debt has un -
favorable effect on the cost of capital and value
of the firm:
Because debt becomes risky

Assume that the firm has EBIT of Rs 4,00,000. The
firm has 10% debentures of Rs 10,00, 000 and the cost
of equity is 16%. Find out the value of the firm and
overall cost of capital according to traditional
approach.

Management, Bangalore
Prof. Anand Patil, Alliance School of

If the firm increases the debt by another Rs 5,00,000.
so the debt increases to 11% and cost of equity rises to
17%. Calculate the overall cost of capital and the value
of the firm.

Management, Bangalore
Prof. Anand Patil, Alliance School of

If the firm increases the debt by further Rs 5,00,000.
so the debt increases to 12.5% and cost of equity rises
to 20%. Calculate the overall cost of capital and the
value of the firm.

Management, Bangalore
Prof. Anand Patil, Alliance School of
 Market value of the firm, Value of Equity & Cos of Capital

Debt 10,00,000 15,00,000 20,00,000

EBIT 400000 400000 400000

Interest( @10% , 11% and 12.5%on Debt) 100000 165000 250000

Management, Bangalore
Prof. Anand Patil, Alliance School of
EAESH 300,000 235,000 150,000
Cost of Equity(Ke) 0.16 0.17 0.2
Market Value of the equity Shares ( Rs) 1875000 1382353 750000
VE = (EAESH/Ke)
Market Value of Debt (VD) 1000000 1500000 2000000
Total Value of the firm (MV=VE+VD) 2875000 2882353 2750000

Cost of Capital (K0 = EBIT/V) 0.13913 0.138776 0.145455

13.91 13.87 14.5
Prof. Anand Patil, Alliance School of
Management, Bangalore