



Traditional Approach

The Net Income theory and Net Operating Income theory stand in extreme forms. Traditional
approach stands in the midway between these two theories. This Traditional theory was advocated
by financial experts Ezta Solomon and Fred Weston. According to this theory a proper and right
combination of debt and equity will always lead to market value enhancement of the firm. This
approach accepts that the equity shareholders perceive financial risk and expect premiums for
the risks undertaken. This theory also states that after a level of debt in the capital
structure, the cost of equity capital increases.
Example:
Let us consider an example where a company has 20% debt and 80% equity in its capital structure.
The cost of debt for the company is 9% and the cost of equity is 14%. According to the traditional
approach the overall cost of capital would be:
The Net Income theory and Net Operating Income theory stand in extreme forms. Traditional
approach stands in the midway between these two theories. This Traditional theory was advocated
by financial experts Ezta Solomon and Fred Weston. According to this theory a proper and right
combination of debt and equity will always lead to market value enhancement of the firm. This
approach accepts that the equity shareholders perceive financial risk and expect premiums for
the risks undertaken. This theory also states that after a level of debt in the capital
structure, the cost of equity capital increases.
WACC = (Weight of debt x cost of debt) + (Weight of equity x cost of equity)
⇒ (20% x 9%) + (80% x 14%)
⇒ 1.8 + 11.2 ⇒ 13%
If the company wants to raise the debt portion in the capital structure to be 50%, the cost of debt
as well as equity would increase due to the increased risk of the company. Let us assume that the
cost of debt rises to 10% and the cost of equity to 15%. After this scenario, the overall cost
of capital would be:
WACC = (50% x 10%) + (50% x 15%)
⇒ 5 + 7.5 ⇒ 12.5%
WACC = (50% x 10%) + (50% x 15%)
⇒ 5 + 7.5 ⇒ 12.5%
In the above case, although the debt-equity ratio has increased, as well as their respective costs,
the overall cost of capital has not increased, but has decreased. The reason is that debt involves
lower cost and is a cheaper source of finance when compared to equity. The increase in specific
costs as well the debt-equity ratio has not offset the advantages involved in raising capital by a
cheaper source, namely debt.
Now, let us assume that the company raises its debt percentage to 70%, thereby pushing down the
equity portion to 30%. Due to the increased and over debt content in the capital structure, the
firm has acquired greater risk. Because of this fact, let us say that the cost of debt rises to
15% and the cost of equity to 20%. In this scenario, the overall cost of capital would be:
WACC = (70% x 15%) + (30% x 20%)
⇒ 10.5 + 6 ⇒ 16.5%
This decision has increased the company's overall cost of capital to 16.5%.
The above example illustrates that using the cheaper source of funds, namely debt, does not
always lower the overall cost of capital. It provides advantages to some extent and beyond
that reasonable level, it increases the company's risk as well the overall cost of capital.
These factors must be considered by the company before raising finance via debt.
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