Traditional approach is an intermediate approach between the net income approach and net operating income approach. According to this approach.
(1) An optimum capital structure does exist.
(2) Market value of the firm can be increased and average cost of capital can be reduced through a prudent manipulation of leverage.
(3) The cost of debt capital increases if debts are increases beyond a definite limit. This is because the greater the risk of business the higher the rate of interest the creditors would ask for. The rate of equity capitalization will also increase with it. Thus there remains no benefit of leverage when debts are increased beyond a certain limit. The cost of capital also goes up.
Thus at a definite level of mixture of debts to equity capital, average cost of capital also increases. The capital structure is optimum at this level of the mix of debts to equity capital.
The effect of change in capital structure on the overall cost of capital can be divided into three stages as follows;
In the first stage the overall cost of capital falls and the value of the firm increases with the increase in leverage. This leverage has beneficial effect as debts as debts are less expensive. The cost of equity remains constant or increases negligibly. The proportion of risk is less in such a firm.
A stage is reached when increase in leverage has no effect on the value or the cost of capital, of the firm. Neither the cost of capital falls nor the value of the firm rises. This is because the increase in the cost of equity due to the assed financial risk offsets the advantage of low cost debt. This is the stage wherein the value of the firm is maximum and cost of capital minimum.
Beyond a definite limit of leverage the cost of capital increases with leverage and the value of the firm decreases with leverage. This is because with the increase in debts investors begin to realize the degree of financial risk and hence they desire to earn a higher rate of return on equity shares. The resultant increase in equity capitalization rate will more than offset the advantage of low-cost debt.
It follows that the cost of capital is a function of the degree of leverage. Hence, an optimum capital structure can be achieved by establishing an appropriate degree of leverage in capital structure.