Traditional Approach

Introduction
• Traditional Approach was propounded by Ezra Soloman in 1963.
• This approach rejects NI theory and NOI theory.
• This approach is the compromise between NI and NOI Approach.
• This approach neither assumes Ke and declining WACC like NI approach,
nor increasing Ke and constant Kd and Ko like NOI.
• According to this approach, WACC decreases only up to a certain level of
financial leverage and starts increasing beyond certain level of debt
equity mix.
• A firm has an optimum capital structure when WACC is minimum and
market value is maximum.
• WACC declines with moderate level of leverage because expensive
equity is replaced with low Kd.
• This theory assumes that upto a certain level of debt, it remains
cheaper than equity and beyond that level, it becomes costly.
• The increased debt results in decrease in WACC only upto a stage
where benefit of low cost of debt is more than the increase in Ke due
to increase in financial risk.
• Financial leverage is beneficial when Kd plus increased Ke is less than
the Ke that was before debt financing.
• The moment when Kd plus increased Ke becomes higher that the ke
that existed before debt financing, the additional us eof debt
increases the WACC and the decision of increasing debt becomes
unfavourable and the value of firm declines.
Stages under Traditional Approach
• The value of firm may first increase with moderate leverage, reach the
maximum value and then starts declining with higher financial
leverage.
• This is because the WACC first decreases and after reaching the
minimum, it starts increasing with increase in financial leverage.
• There are 3 stages under this theory showing the relationship
between capital structure and firm value.
First Stage: Increasing Value
• Ke either remains constant or rises slightly with increase in debt.
• The increase in Ke is less than the advantage in cost due to lower Kd
than equity.
• Kd remains constant, since it is considered as a rational decision.
• Ko decreases with increase in leverage and thus the total value of firm
also increases
Second Stage: Optimum Value
• Ke increases faster than it increases at the first stage when debt
increases.
• The benefit of low Kd is wiped off by increase in Ke beyond certain
level.
• The firm reaches at the stage of maximum WACC and maximum value
of firm at certain level of debt equity mix whereoptimum capital
structure is attained.
Third Stage: Declining Value
• As debt is increased beyond certain level, the increase on Ke,
becomes greater than the advantage of low Kd and therefore WACC
increases and the market value of the firm decreases.
• The value of the firm goes on declining with every increase in debt
replacing the equity.
• This happens because investors perceive a higher degree of financial
risk and demand a higher rate of return on equity, which exceeds the
advantage of low Kd.
Graphical Presentation
• The COC curve is convex to the X axis which shows that in the beginning when
there is no debt or a little debt; the COC is higher; as more debt is introduced it
goes on declining and there is specific point at which the COC is minimum and
after this point the COC starts increasing with the introduction of more and more
debt in e capital structure.
Ke
Cost of Capital Ko

Kd

Optimum Leverage Range

Stage - 2
Stage - 1 Stage - 3
0 Financial Leverage

As per this theory, the Optimal Capital Structure would fall somewhere in the second stage
Optimal Capital Structure under
Traditional Approach
• Ko declines when debt is used in capital structure and it is possible to
attain optimum capital structure.
• The capital structure is optimum at the stage of debt-equity mix
where the Ko is minimum and the value of the firm is maximum.
Criticisms of Traditional Approach
1. The theory assumes that investors value of the levered firms more
than the unlevered firms is not practically correct.
2. Risk for share holders does not increase with additional debt for
financially sound firms.
3. Investors perception about risk of leverage does not change for the
same firm at different levels of leverage.
4. Optimum capita structure is affected by tax deductibility of interest
and other capital market factors, which are ignored.