Financial Management - CAPITAL STRUCTURE THEORIES
Traditional approach - CAPITAL STRUCTURE THEORIES
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The traditional view has emerged as a compromise to the extreme positions taken by the net income approach.
Traditional approach
The traditional view has emerged as a compromise to the extreme positions taken by the net income approach. According to this approach a judicious mix of debt capital and equity capital can increase the value of the firm by reducing the weighted average cost of capital up to a certain level of debt.
Thus, the traditional approach proposes that
1. The cost of debt capital remains more or less constant up to a certain level of leverage but thereafter rises very sharply at an increasing rate
2. The cost of equity capital remains more or less constant or rises only gradually up to a certain degree of leverage and rises very sharply thereafter
3. The average cost of capital, as a result of the above behaviour of cost of debt and cost of equity decreases up to a certain point, remains more or less unchanged for moderate increases in leverage thereafter and rises beyond a certain point
This traditional approach is not very clearly or sharply defined as the net income or net operating income approaches.
The main proposition of the traditional approach is that the cost of capital is dependent on the capital structure and there is an optimal capital structure which minimizes the cost of capital. At this optimal capital structure point the real marginal cost of debt and cost of equity will be the same. Before this optimal point, the real marginal cost of debt is less than the real marginal cost of equity and beyond the optimal point the real marginal cost of debt is more than the real marginal cost of equity
The traditional view has emerged as a compromise to the extreme positions taken by the net income approach. According to this approach a judicious mix of debt capital and equity capital can increase the value of the firm by reducing the weighted average cost of capital up to a certain level of debt.
Thus, the traditional approach proposes that
1. The cost of debt capital remains more or less constant up to a certain level of leverage but thereafter rises very sharply at an increasing rate
2. The cost of equity capital remains more or less constant or rises only gradually up to a certain degree of leverage and rises very sharply thereafter
3. The average cost of capital, as a result of the above behaviour of cost of debt and cost of equity decreases up to a certain point, remains more or less unchanged for moderate increases in leverage thereafter and rises beyond a certain point
This traditional approach is not very clearly or sharply defined as the net income or net operating income approaches.
The main proposition of the traditional approach is that the cost of capital is dependent on the capital structure and there is an optimal capital structure which minimizes the cost of capital. At this optimal capital structure point the real marginal cost of debt and cost of equity will be the same. Before this optimal point, the real marginal cost of debt is less than the real marginal cost of equity and beyond the optimal point the real marginal cost of debt is more than the real marginal cost of equity
The traditional approach implies
that investors’ value leveraged companies more than the unlevered companies.
This implies that they are prepared to pay a premium for the shares of such
levered companies.
The contention of the traditional approach that any addition of debt in sound companies does not really increase the riskiness of the business and the shares of the company is not defendable.
Therefore there is no sufficient justification for the assumption
However the existence of an optimum capital structure can be justified and supported on two counts: tax deductibility of interest payments on debt capital and other market imperfections
The contention of the traditional approach that any addition of debt in sound companies does not really increase the riskiness of the business and the shares of the company is not defendable.
Therefore there is no sufficient justification for the assumption
However the existence of an optimum capital structure can be justified and supported on two counts: tax deductibility of interest payments on debt capital and other market imperfections
Tags : Financial Management - CAPITAL STRUCTURE THEORIES
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