Traditional Approach

The Traditional Approach to capital structure sits between the two extremes of the Net Income (NI) and Net Operating Income (NOI) approaches. It acknowledges that a company's capital structure (mix of debt and equity) does affect its value and cost of capital, but not in a way that is always favorable with increased debt.

Key Ideas of the Traditional Approach

• Capital Structure Matters (to a Point): Unlike the NOI approach, the traditional approach believes that a company's value and cost of capital are influenced by its debt-equity mix.
• Optimal Range Exists: There's an optimal range or level of debt where a company can maximize its value and minimize its overall cost of capital.
• Debt Isn't Always Better: While initial debt can lower the cost of capital, too much debt increases risk and ultimately decreases value.
• Balances Cost and Risk: The traditional approach focuses on balancing the benefits of cheaper debt with the increasing risk it brings to both shareholders and debt holders.
• Intermediate Approach: It takes elements from both NI (capital structure matters) and NOI (cost of capital eventually increases with leverage) approaches.

Core Principles of the Traditional Approach

• Initial Debt is Beneficial: Using some debt in the capital structure initially is advantageous.
  • Debt is often cheaper than equity, lowering the overall cost of capital.
  • This advantage can initially outweigh the increase in financial risk and thus increases the firm value.
• Rising Cost of Equity (k_e): As a company increases leverage (debt), the cost of equity (k_e) will rise to compensate for increased risk.
  • However, this rise in ke may not be enough to offset the cheaper cost of debt, resulting in an overall decline in cost of capital in this initial phase.
• Rising Cost of Debt (k_i): As debt increases further, even the cost of debt (k_i) can start to rise, as lenders start to perceive a higher risk of default and ask for higher interest rates.
• Optimal Point: There is an optimal level where the marginal cost of debt (both explicit and implicit) is equal to the real cost of equity. Below this level, debt is less expensive, and above this level, debt is more expensive.
• U-Shaped Cost of Capital Curve: This concept is often illustrated using a U-shaped cost of capital (k₀) curve:
  • Phase 1: Decreasing k₀: Initial debt reduces the overall cost of capital and increases firm value.
  • Phase 2: Stable k₀: At a specific range of debt levels, the overall cost of capital remains more or less the same, and firm value is relatively constant.
  • Phase 3: Increasing k₀: Excessive debt increases the overall cost of capital and reduces firm value as risk increases significantly for both debt and equity holders.

Variations within the Traditional Approach

There are some slight variations in how this theory is interpreted:

1. k_e Increases After a Certain Point: One variation suggests that the cost of equity doesn't rise immediately with debt, but only after a certain level of leverage is reached.
   • This means that companies can reduce their cost of capital significantly with the initial use of debt.
2. Range of Optimal Structures: Another variant suggests that instead of one single optimum point, there's a range of debt-equity mixes where the cost of capital is minimized and the firm value is maximized.
   • Within this range, changes in leverage have very little effect on the company's value.

Example of Traditional Approach in Action

Let's use the examples from the text to see the theory in action:

Initial Situation

• Debt: 100,000 (10% interest rate)
• Equity: based on an equity cap rate of 16%, making the value of equity 187,500.
• EBIT: Rs 40,000

Increased Debt - Phase 1

The company issues an additional Rs 50,000 in debt, using that to retire equity. As a result, k_i rises to 11%, and k_e rises to 17%.

• Result: Company value has slightly increased and overall cost of capital has decreased. This is in Phase 1.

Increased Debt Further - Phase 3

The company issues another additional Rs 50,000 in debt, using that to retire equity. As a result, k_i rises to 12.5%, and k_e rises to 20%.

• Result: Company value has decreased and overall cost of capital has increased. This is now in Phase 3.

Key Observations From Example

• Initial use of debt slightly increased the value and reduced the cost of capital.
• Beyond a certain level, the increased cost of debt and equity (due to higher risk) reduces the total value and increased the cost of capital.
• The optimal point lies somewhere between the first example and the third example.

Conclusion of the Traditional Approach

The Traditional Approach acknowledges that a company's capital structure affects its value and cost of capital, but not in a straightforward, always-increasing way. It recognizes that initially, debt is a cheaper source of financing that, when used, has an overall beneficial effect in lowering the WACC and increasing firm value, but that beyond a certain level, the increasing risk associated with the increased use of debt leads to higher costs for both equity and debt financing, which in turn lowers the value of the company.

This approach suggests that companies should seek an optimal capital structure where they balance the benefits of debt against the increased risks of high leverage. It highlights the need for a nuanced approach rather than blindly using more or less debt.