Optimal Capital Structure and Value Maximization in Traditional Approach
The traditional approach to finance emphasizes achieving the optimal capital structure by balancing debt and equity to minimize the Weighted Average Cost of Capital (WACC) and maximize the firm's overall value. By understanding the relationship between the cost of debt and equity, financial leverage, and the impact on WACC, firms can strive to reach an optimal mix that enhances value while managing financial risks effectively.
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Presentation Transcript
Traditional Approach Traditional Approach Assumptions Apart from the general assumptions, the following additional assumptions are made The Cost of Debt (Kd) is always less than the Cost of Equity (Ke). Kdand Kevary with the change in debt equity mix. Increase in cost of equity is more steeper and higher than increase in cost of debt.
Theory Debt is a cheaper source of finance than equity due to tax saving effect and investor's risk expectations. Use of cheaper debt funds in total capital structure will reduce the overall or weighted average cost of capital. Hence, as the degree of financial leverage increases the Weighted Average Cost of Capital (WACC) will decline with every increase in the debt content in total funds employed.
Hence, if financial leverage increases beyond the acceptable limit, the cost of debt and cost of equity start rising. This is because of high financial risk associated with the firm. The increasing cost of capital owing to increased financial risk and increasing cost of debt makes the overall cost of capital to increase. Therefore, the firm should strive to reach the optimal capital structure and maximize its total value through a judicious use of both debt and equity.
At the optimal capital structure, the overall cost of capital will be minimum and the value of firm is maximum. As per traditional approach, the firm should try to achieve the optimal capital structure by minimizing WACC and maximizing its value.
