assumptions ,example

1. Financial Management (KMB 204)
Capital Structure Theory
Traditional Approach
Prepared by :
Taru Maheshwari
Sr.Asstt.Prof. ABESEC
AKTU (Lucknow)

2. Traditional Approach
Capital structure theories and its different approaches put forth the relation between the proportion of
debt in the financing of a company’s assets, the weighted average cost of capital (WACC) and the
market value of the company. Net Income Approach and Net Operating Income Approach are the two
extremes Approach are the two extremes, traditional approach, advocated by Ezta Solomon and Fred
Weston is a midway approach also known as “intermediate approach”.
According to this theory a firm can reduce cost of capital and can increase value of firm by including
debt financing in its capital structure initially but after a certain level it COC start increasing due to
financial risk for the company.

3. Assumptions
• The rate of interest on debt remains constant for a certain period and thereafter with an increase in leverage, it increases.
• The expected rate by equity shareholders remains constant or increase gradually. After that, the equity shareholders starts
perceiving a financial risk and then from the optimal point and the expected rate increases speedily.
• As a result of the activity of rate of interest and expected rate of return, the WACC first decreases and then increases. The
lowest point on the curve is optimal capital structure.

4. Example
• Compute the market value of a firm, value of shares and the average cost
of capital from the following information :
• Net operating income 2,00,000 • Total investment 10,00,000
Equity capitalization rate
• If the firm uses no debt 10%
• If the firm uses 4,00,000 debt 11%
• If the firm uses 6,00,000 debt 13%
Assume that 4,00,000 debentures can be raised at 5% rate whereas 6,00,000
debentures can be raised at 6% rate of interest.

5. Solution
• Computation of market value of firm, value of shares & average cost of capital
•
No debt 4,00,000 deb @ 5% 6,00,000 deb
@6%
Net operating
Income
200,000 200,000 200,000
Less: Interest 20000 36000
EBT 200000 180000 164000
Equity Cap Rate 10% 11% 13%
Market Value of
shares
2000000 1636363 1261538
Market value of
debt
Nil 400000 600000
VALUE OF FIRM 20,00,000 20,36,363 1861,538
COC 10% 9.8% 10.7%