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    Question

    According to traditional approach the average cost of capital ________________________________.

    A

    Remains constant up to a degree of leverage and rise sharply thereafter with even increase in leverage

    B

    Rises constantly with increase in leverage

    C

    Decreases up to a certain point, remains unchanged for moderate increase in leverage and rises beyond a certain point

    D

    Decreases at an increasing rate with increase in leverage

    E

    Increase up to certain point remains constant for moderate decrease in leverage and decreases beyond a certain point.

    Medium Open in App

    Updated on : 2022-09-05

    Solution Verified by Toppr

    Correct option is C)

    According to the traditional approach the average cost of capital K

    0 ​

    as a consequence of a behaviour of K

    e ​ and K d ​

    , decreases up to a certain point remains more or less unchanged for moderate increases in leverage thereafter and rises beyond a certain point.

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    Traditional Theory of Capital Structure Definition

    The Traditional Theory of Capital Structure states that a firm's value is maximized when the cost of capital is minimized, and the value of assets is highest.

    ECONOMY ECONOMICS

    Traditional Theory of Capital Structure

    By THE INVESTOPEDIA TEAM Updated August 30, 2021

    Reviewed by ROBERT C. KELLY

    Fact checked by HANS DANIEL JASPERSON

    What Is the Traditional Theory of Capital Structure?

    The traditional theory of capital structure states that when the weighted average cost of capital (WACC) is minimized, and the market value of assets is maximized, an optimal structure of capital exists. This is achieved by utilizing a mix of both equity and debt capital. This point occurs where the marginal cost of debt and the marginal cost of equity are equated, and any other mix of debt and equity financing where the two are not equated allows an opportunity to increase firm value by increasing or decreasing the firm’s leverage.

    KEY TAKEAWAYS

    The traditional theory of capital structure says that for any company or investment there is an optimal mix of debt and equity financing that minimizes the WACC and maximizes value.

    Under this theory, the optimal capital structure occurs where the marginal cost of debt is equal to the marginal cost of equity.

    This theory depends on assumptions that imply that the cost of either debt or equity financing vary with respect to the degree of leverage.

    Understanding the Traditional Theory of Capital Structure

    The traditional theory of capital structure says that a firm's value increases to a certain level of debt capital, after which it tends to remain constant and eventually begins to decrease if there is too much borrowing. This decrease in value after the debt tipping point happens because of overleveraging. On the other hand, a company with zero leverage will have a WACC equal to its cost of equity financing and can reduce its WACC by adding debt up to the point where the marginal cost of debt equals the marginal cost of equity financing. In essence, the firm faces a trade-off between the value of increased leverage against the increasing costs of debt as borrowing costs rise to offset the increase value. Beyond this point, any additional debt will cause the market value and to increase the cost of capital. A blend of equity and debt financing can lead to a firm's optimal capital structure.

    The traditional theory of capital structure tells us that wealth is not just created through investments in assets that yield a positive return on investment; purchasing those assets with an optimal blend of equity and debt is just as important. Several assumptions are at work when this theory is employed, which together imply that the cost of capital depends upon the degree of leverage. For example, there are only debt and equity financing available for the firm, the firm pays all of its earnings as a dividend, the firm's total assets and revenues are fixed and do not change, the firm's financing is fixed and does not change, investors behave rationally, and there are no taxes. Based on this list of assumptions, it is probably easy to see why there are several critics.

    The traditional theory can be contrasted with the Modigliani and Miller (MM) theory, which argues that if financial markets are efficient, then debt and equity finance will be essentially interchangeable and that other forces will indicate the optimal capital structure of a firm, such as corporate tax rates and tax deductibility of interest payments.

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    According to traditional approach the average cost of capital

    According to traditional approach, the average cost of capital _______________. a) Remains constant up to a degree of leverage and rises sharply thereafter with every increase in leverage b) Rises constantly with increase in leverage c) Decrease up to certain point, remains unchanged for moderate increase in leverage and rises beyond a certain point d) Decrease at an increasing rate with increase in leverage

    According to traditional approach the average cost of capital

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    Examveda

    According to traditional approach, the average cost of capital _______________.

    A. Remains constant up to a degree of leverage and rises sharply thereafter with every increase in leverage

    B. Rises constantly with increase in leverage

    C. Decrease up to certain point, remains unchanged for moderate increase in leverage and rises beyond a certain point

    D. Decrease at an increasing rate with increase in leverage

    Answer: Option C

    Solution(By Examveda Team)

    According to traditional approach, the average cost of capital decrease up to certain point, remains unchanged for moderate increase in leverage and rises beyond a certain point.

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