Traditional Approach | TutorsOnNet

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.

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.

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%

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:

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.

We have the best tutors in Finance in the industry. Our tutors can break down a complex Traditional Approach problem into its sub parts and explain to you in detail how each step is performed. This approach of breaking down a problem has been appreciated by majority of our students for learning Traditional Approach concepts. You will get one-to-one personalized attention through our online tutoring which will make learning fun and easy. Our tutors are highly qualified and hold advanced degrees. Please do send us a request for Traditional Approach tutoring and experience the quality yourself.

If you are stuck with a Traditional Approach Homework problem and need help, we have excellent tutors who can provide you with Homework Help. Our tutors who provide Traditional Approach help are highly qualified. Our tutors have many years of industry experience and have had years of experience providing Traditional Approach Homework Help. Please do send us the Traditional Approach problems on which you need Help and we will forward then to our tutors for review.