Traditional Theory of Capital Structure

In order to understand the concept, you should first examine the relationship between the weighted average cost of capital and value of a firm in ‘Understanding Capital Structure Theories’.

Understand

According to the ‘traditional’ theory of capital structure, the value of a company is dependent on the capital structure or gearing level and it will be on optimal level or, an optimal capital structure exists when the weighted average cost of capital is at a minimum limit and market value of the company at maximum. The optimal capital structure will exist up to a certain level, after which it will stay constant and begins to drop due to more debt issuance and demand for more return from equity holders (because of increased risk exposure by having more debt), resulting in increased weighted average cost of capital.

How it works

The theory can be demonstrated on a diagram in which:

Ke = Cost of Equity

Kd = Cost of Debt

Ko = Overall Cost of Capital or Weighted Average Cost of Capital

K is a point where an optimal capital structure exists and according to the theory at this point, the company will have maximum market value.

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