The traditional approach to capital structure suggests that there exists an optimal debt to equity ratio where the overall cost of capital is the minimum and the market value of the firm is the maximum. On either side of this point, changes in the financing mix can bring positive change to the value of the firm. Before this point, the marginal cost of debt is less than the cost of equity and after this point vice-versa.
Capital Structure Theories and their different approaches put forth the relationship between the proportion of debt in the financing of a company’s assets, the weighted average cost of capital (WACC) and the market value of the company. While the Net Income Approach and Net Operating Income Approach are the two extremes, the traditional approach, advocated by Ezta Solomon and Fred Weston is a midway approach also known as the “intermediate approach”.
Traditional Approach to Capital Structure:
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 the reduction in 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 market value of the firm 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 to the WACC. Above the threshold, the WACC increases, and the market value of the firm starts a downward movement.
Assumptions under Traditional Approach:
- The rate of interest on debt remains constant for a certain period and thereafter with an increase in leverage, it increases.
- The expected rate by equity shareholders remains constant or increase gradually. After that, the equity shareholders starts perceiving a financial risk and then from the optimal point and the expected rate increases speedily.
- As a result of the activity of rate of interest and expected rate of return, the WACC first decreases and then increases. The lowest point on the curve is optimal capital structure.
Diagrammatic Representation of Traditional Approach to Capital Structure:
Example Explaining Traditional Approach:
Consider a fictitious company with the following data.
|Particulars||Case 1||Case 2||Case 3||Case 4||Case 5|
|Weight of debt||10%||30%||50%||70%||90%|
|Weight of equity||90%||70%||50%||30%||10%|
|Cost of debt||10%||11%||12%||14%||16%|
|Cost of equity||17%||18%||19%||21%||23%|
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 financial leverage of the company, 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.
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 financial leverage of the company, 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 market value of the company.
Quiz on Capital Structure Theory
This quiz will help you to take a quick test of what you have read here.