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The Traditional Approach To Capital Structure

1201 words - 5 pages

The traditional approach to capital structure
The traditional approach stresses the benefits of using the combination of cheaper debt and equity finance to find the optimal capital structure, so the total value of firms will be increased with the sensible debt. (Watson and Head, 2013) Of cause, the model was created which based on a certain assumption 1) There is no tax at a personal or a corporate level. 2) The perpetual debt finance and ordinary equity shares are the financial choices for firms. 3) The capital structure can be changed without incurring issue or redemption costs. 4) Any debt finance is up or down, which will lead to the same situation in equity finance. 5) All distributable earnings will be regarded as dividends by companies. 6) The relative business risks of companies keep existing over time. 7) The earnings and dividends of a company will not be increased over time.
To understand this traditional approach in depth, the theory model is illustrate in figure 1.

(Watson and Head, 2013)
As the figure showed, the cost of equity curve (k_e) is presenting a rising trend with the increasing gearing because of the growing level of financial risks of shareholders. The steeper rate of curve (k_e) at the higher level of gearing which embodies that the investment value of shareholders is being threatened by the risk of company bankruptcy. It can be seen that the cost of debt (K_d) is not increasing until at level of gearing. Hence the bankruptcy risks also threat to the debt holders. The point A stands for the company began to use the cheaper debt finance instead of the expensive equity, it will lead to the lower weight average cost of capital (WACC) initially. When the WACC curve reduced to point B, it got the optimal capital structure at point X where the company value is maximized and the WACC is minimized. However, WACC will eventually be forced gear up. As the same as the cost of equity and debt, it also has a faster rate at the high gearing.

Miller And Modigliani Theory
(I).The Net Income Approach
Miller and Modigliani’s net operating income approach emphasizes the value of company is irrelevant to the capital structure which depends on the actual assets of firms rather than the market value of debt and equity.Based on the assumptions outlined in the traditional approach, this model added an extra assumption that the bankruptcy risk of capital market could be ignored. The figure2. is used to explain this capital structure approach in detail.

(Watson and Head, 2013)
The linear relationship between the cost of equity curve (k_e) and the level of gearing illustrated that the cost of equity will grow up along with increasing financial risks faced by shareholders. The cost of debt curve (K_d) become a straight line parallel to the level of gearing, the reason is that the cost of debt will not face bankruptcy risks and not...

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