What is the Traditional Approach of Capital Structure?

The cost structure of value is also known as the capital structure of valuing a firm. The theory of the traditional structure of valuing a firm suggests that there is an optimal debttoequity ratio that has a minimum overall cost of capital and maximum market value of a firm. On the sides of this point, changes in the financing mix can bring positive changes to the value of a firm. Moreover, before this point, the marginal cost of debt is less than the equity cost; and after this point, the cost of equity is less than the cost of debt.

The Traditional Approach

The traditional approach to capital structure stresses the fact that there is a right mix of equity and debt in the capital structure, at which the market value of a company is maximum.

  • This approach tells that in the capital structure of a company, debt should exist in the capital structure only up to a specific point. Beyond this point, any increase in leverage would result in a reduction in the value of the firm.

  • In other words, it means that there is an optimum value of debt-to-equity ratio at which the Weighted Average Cost of Capital (WACC) is the lowest, while the market value of the firm is the highest.

  • After the specific debttoequity ratio, the cost of equity goes up to offer a detrimental effect to the WACC. When the debt-to-equity ratio goes above the threshold, the WACC goes up and the market value of the firm starts to go down.

Assumptions under the Traditional Approach

Following are the assumptions under the Traditional Approach −

  • The rate of interest on the debt stays constant for a certain period and after that, with an increase in leverage, it goes up.

  • The expected rate of interest in investment by equity shareholders remains constant or increases gradually. After reaching the threshold, the equity shareholders start perceiving a financial risk, and then from the optimal point, the expected rate of interest increases quickly.

  • As a result of the rate of interest and expected rate of return working together, the WACC first starts to decrease, and then it increases. In the capital structure graph, the lowest point refers to the optimal ratio.

An increase or decline in the optimal structure of capital affects the value of a firm. Hence, when the overall cost of capital is diminished up to a specific level of debt, the optimal capital structure comes into effect to increase the value of a company.

Updated on: 24-Dec-2021

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