Traditional Theory of Capital Structure

What Is the Traditional Theory of Capital Structure?

The traditional theory of capital structure states that when the weighted average cost of capital (WACC) is limited, and the market value of assets is amplified, an optimal structure of capital exists. This is accomplished by using a mix of both equity and debt capital. This point happens where the marginal cost of debt and the marginal cost of equity are equated, and some other mix of debt and equity financing where the two are not equated permits an opportunity to increase firm value by expanding or decreasing the firm's leverage.

Figuring out the Traditional Theory of Capital Structure

The traditional theory of capital structure says that a firm's value increases to a certain level of debt capital, after which it will in general stay steady and ultimately starts to diminish assuming there is too much borrowing. This reduction in value after the debt tipping point happens due to overleveraging. Then again, a company with zero leverage will have a WACC equivalent to its cost of equity financing and can reduce its WACC by adding debt up to the point where the marginal cost of debt equals the marginal cost of equity financing. Fundamentally, the firm faces a compromise between the value of increased leverage against the rising costs of debt as borrowing costs rise to offset the increase value. Past this point, any extra debt will cause the market value and to increase the cost of capital. A blend of equity and debt financing can lead to a firm's optimal capital structure.

The traditional theory of capital structure lets us know that wealth isn't just made through investments in assets that yield a positive return on investment; purchasing those assets with an optimal blend of equity and debt is just as important. Several suspicions are working when this theory is employed, which together suggest that the cost of capital relies on the degree of leverage. For instance, there are just debt and equity financing accessible for the firm, the firm pays its earnings as a dividend, the firm's all's total assets and incomes are fixed and don't change, the firm's financing is fixed and doesn't change, investors act objectively, and there are no taxes. In view of this rundown of suspicions, it is likely simple to see the reason why there are several pundits.

The traditional theory can be stood out from the Modigliani and Miller (MM) theory, which contends that if financial markets are efficient, then, at that point, debt and equity finance will be basically interchangeable and that different powers will demonstrate the optimal capital structure of a firm, for example, corporate tax rates and tax deductibility of interest payments.

Features

• This theory relies upon suspicions that infer that the cost of one or the other debt or equity financing differ with respect to the degree of leverage.
• Under this theory, the optimal capital structure happens where the marginal cost of debt is equivalent to the marginal cost of equity.
• The traditional theory of capital structure expresses that for any company or investment there is an optimal mix of debt and equity financing that limits the WACC and expands value.