Traditional

Theory of
Capital
Structure
K H U S H I G U P TA , S A N D E E P
RAJBHER, MUNIR KHAN,
MOHIT
Traditional Approach to Capital Structure

Table of Contents

1.Traditional Approach to Capital Structure

2.Assumptions under Traditional Approach

3.Diagrammatic Representation of Traditional Approach to Capital Structure

4.Example Explaining Traditional Approach

5.Numericals
Traditional Approach

 The traditional approach, advocated by Ezta Solomon & Fred Weston.

 It is the mix of net income approach and net operating income approach

 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 a reduction in
the value f the firm.

The traditional approach to capital structure suggests an optimal debt to equity

ratio where the overall cost of capital is the minimum and the firm’s market value
is the maximum. On either side of this point, changes in the financing mix can
bring positive change to the firm’s value. Before this point, the marginal cost of
debt is less than the cost of equity, and after this point, vice-versa. 
Traditional Approach
The 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 a reduction in the 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 firm’s market value 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 on the WACC. Above the threshold, the WACC increases, and
the firm’s market value starts a downward movement.
 Assumptions under Traditional Approach
There are only two sources of fund used by a firm; debt & shares.

The interest rate on the debt remains constant for a certain period, and after
that, it increases with an increase in leverage. 
The expected rate by equity shareholders remains constant or increases
gradually.
The operating profile (EBIT) are not expected to grow.

The business risk remains constant.

The firm has a perpetual life

The investors behave rationally

Diagrammatic Representation of Traditional Approach to
Capital Structure
 Example Explaining Traditional Approach
Particulars Case 1 Case 2  Case 3 Case 4 Case 5

Weight  of
10% 30% 50% 70% 90%
debt

Weight  of
90% 70% 50% 30% 10%
equity

Cost of debt 10% 11% 12% 14% 16%

Cost of equity 17% 18% 19% 21% 23%

WACC 16.3% 15.9% 15.5% 16.1% 16.7%

Explaining Example:-1
From case 1 to case 3, the company increases its financial leverage, and as a
result, the debt increases from 10% to 50%, and equity decreases from 90% to
50%. The cost of debt and equity also rises, as stated in the table above,
because of the company’s higher exposure to risk. The new WACC is decreased
from 16.3% to 15.5%.

As observed, with the increase in the company’s financial leverage, the overall
cost of capital reduces, despite the individual increases in the cost of debt and
equity, respectively. The reason is that debt is a cheaper source of finance.
Explaining Example:-2
Now, look at the situation in case 3 to case 5, the company increases its financial
leverage further, and as a result, the debt is increased from 50% to 90% and
equity from 50% to 10%. The cost of debt and equity rises further. The new
WACC is increased from 15.5% to 16.7%. As observed, with the increase in the
company’s financial leverage, the overall 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 company’s market value.
Numericals:-1
Solution
Numerical:-2
Solution