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’.
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