Traditional Approach | Capital Structure Theories | Relevant Theory | Corporate Finance
Traditional approach is extended form of Net Income approach. Net Income approach only talks about the effect of leverage on value of firm and cost of capital but does not talk about the Optimal Capital Structure. Optimal Capital structure is that combination of debt and equity which maximize the wealth of shareholders.
The traditional approach to capital structure and valuation assumes that there is an optimal capital structure and that management can increase the total value of the firm through the judicious use of financial leverage.
Initially when firm uses debt capital overall cost capital decreases because cost of debt is lower than cost of equity, but after some time excessive use of debt leads to financial risk and cost of debt starts to increase which ultimately increase the overall cost of capital.
Assumptions of Traditional Approach
i. Initially cost of debt is lower than cost of equity. (Kd < Ke)
ii. Excessively use of debt capital leads to financial risk
iii. Initially cost of debt and cost of equity both remain constant but after particular leverage ratio both will be increased.
On the above figure, initially cost of debt and cost of equity are constant and overall cost of capital is decreasing and total value of firm is increasing as the leverage ratio increase. Here, leverage ratio X is optimal capital structure when the total value of firm is maximum. If leverage ratio is further increased more than X, that may cause financial risk and cost of capital starts to increase and total value of firm starts to decline.