TRADITIONAL APPROACH-Capital Structure

 

TRADITIONAL APPROACH-Capital Structure

Meaning

The Traditional Approach to capital structure states that there is an optimum capital structure at which the overall cost of capital (WACC) is minimum and the value of the firm is maximum.

According to this approach:

  • A firm can increase its value by using debt in a reasonable proportion along with equity.
  • Debt is cheaper than equity because interest on debt is tax-deductible and lenders take lower risk.
  • However, excessive use of debt increases financial risk and the cost of equity.
  • Therefore, a proper debt–equity mix is required to achieve an optimum capital structure.

Assumptions:

  1. Cost of debt remains constant up to a certain level.
  2. Cost of equity increases with increased financial risk.
  3. Moderate use of debt reduces overall cost of capital.
  4. Beyond the optimum point, excessive debt increases WACC and reduces firm value.

Tips to Solve Traditional Approach Problems (Capital Structure Sums)

Most problems ask you to find:

  1. Value of Firm
  2. Cost of Equity (Ke)
  3. Overall Cost of Capital (Ko/WACC)
  4. Optimum Capital Structure

 

Problem:

1.      Net Operating Income                                                            :  Rs.3,00,000

2.      Total Investment                                                                     : Rs.15,00,000

3.      Equity Capitalisation Rate:

a.       If the firm does not use debt                                      :10%

b.      In the firm uses a debt of Rs.6,00,000                       :11%

c.       If the firm uses a debt of Rs.Rs.6,00,000                   :12%

The debt of Rs.6, 00,000 can be raised at 5% rate of interest while debt of Rs.9,00,000 can be raised at 7 %.

Solution

Traditional Approach

a)Market Value of the Firm,b) Value of Equity and Ave.Cost of Capital

 

 

 

 

 

1

Net Operating Income

3,00,000

3,00,000

3,00,000

2

Less : Interest

 

30,000

63,000

3.

Earnings available to Eq.Sh.holders

3,00,000

2,70,000

2,37,000

4.

Divide: Ke

.10

.11

.12

5

Market Value of Shares (S)

30,00,000

24,54,545

19,75,000

6

Add: Market value of Debenture

NIL

6,00,000

9,00,000

7

Value of the firm

30,00,000

30,54,545

28,75,000

8

Ave.Cost of capital EBIT/V

 

 

 

 

EBIT

3,00,000

3,00,000

3,00,000

 

Divide: Value of the firm

30,00,000

30,54,545

28,75,000

 

Cost of capital

.10 or10%

9.82%

10.43%

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