Page 192 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 8: Capital Structure Decision

NOI approach can be graphically shown as below: Notes

From the above graph, it is clear that, as the degree of leverage is increased, K and K remains
o d
at the same level. But cost of equity increases with leverage and exactly neutralises the benefits
of low cost debt. So overall cost of Capital remains at the same level.

8.7.3 Traditional or Intermediate Approach or WACC Approach

This approach is midway between the NI and the NOI approach. The main propositions of this
approach are:
The cost of debt remains almost constant upto a certain degree of leverage but rises thereafter, at
an increasing rate. The cost of equity remains more or less constant or rises gradually up to a
certain degree of leverage and rises sharply thereafter. The cost of capital due to, the behaviour of
the cost of debt and cost of equity, decreases upto a certain point and remains more or less constant
for moderate increases in leverage, thereafter, rises beyond that level at an increasing rate.
In other words NI approach and NOI approach represents two polar cases. The traditional or the
intermediate approach is a midway between these two approaches, because it partly takes the
features of both the approaches.
According to the theory, the value of the firm can be increased or cost of capital can be reduced
by a judicious mix of debt and equity capital. This approach states that, cost of capital is a
function of leverage. So cost of capital decreases upto a certain degree of leverages then it
remains at the same level for certain degrees of leverage and thereafter it rises sharply with the
leverage. So optimum capital structure exists when the cost of capital is minimum or value of
the firm is maximum.
The manner in which cost of capital reacts to the changes in the capital structure can be divided
into three stages.
1. In the first stage, cost of equity remains constant or rises slightly with the debt. But when
it increases, it does not increase fast enough to offset the advantage of low cost debt. Cost
of debt also remains same or rises slightly with the leverage. As the cost of debt is less than
cost of equity, increased use of debt reduces the cost capital during the 1st stage.
2. Once the firm has reached the certain degree of leverage, increased use of debt does not
result in the fall in the overall cost of capital. This is due to the fact that, benefits of low cost
debt are offset by the increase in the cost of equity. Within this range, cost of capital will
be minimum or value of the firm will be maximum.
3. Beyond a certain point, use of debt has unfavourable effect on cost of capital and value of
the firm. This happens because the firm would become more risky to the investors and

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