TRADITIONAL APPROACH Homework Help

TRADITIONAL APPROACH

The preceding discussions clearly show that the Net Income Approach (N) as well as Net Operating Income Approach (NOI) represent two extremes as regards the theoretical relationship between financing decisions as determined by the capital structure, the weighted average cost of capital and total value of me firm. While the MM Approach takes the position mat the use of debt, in the cap structure will always affect the overall cost of capital and the total valuation, the NOI Approach argues that capital structure is totally irrelevant. The MM Approach supports me NOI Approach, the assumptions of MM hypothesis are of doubtful validity. The Traditional Approach is midway between the NI and NOI Approaches, It partakes of some features of both these Approaches. It also known as the Intermediate Approach. It resembles the NI Approach in arguing mat cost of capital and total value of the firm are not independent of me capital structure. But it does subscribe to me view of (NI Approach) that value of a firm will necessarily increase for all degrees leverage. In one respect it shares a feature with the NOI Approach that beyond a certain degree leverage, the overall cost increases leading to a decrease in total value of me firm. But it from the NOI Approach in that ii does not argue mat me weighted average cost of capital is cost for all degrees of leverage.

The crux of the traditional view relating to leverage and valuation is that through judicious use debt-equity proportions, a firm can increase its total value and thereby reduce its overall cost capital. The rationale behind this view is that debt is a relatively cheaper source of funds compared to ordinary shares with a change in me leverage, mat is, using more debt in place equity, a relatively cheaper source of funds replaces a source of funds which involves a higher cost. This obviously causes a decline in me overall cost of capital. If me debt-equity raised further, me firm would become financially more risk to me investors who would penalize firm by demanding a higher equity capitalization rate (k). But me increase in k, may not be so as to neutralize me benefit of using cheaper debt. In other words, me advantages arising out of use of debt is so large mat, even after allowing for higher k, me benefit of tile use of me source of funds is still available, If. however, the amount of debt is increased further, two things likely to happen: (i) owing to increased financial risk, k, will record a substantial rise; (ii) the would become very risky to the creditors who also would like to be compensated by a higher such that k will rise. The use of debt beyond a certain point will, therefore, have me effect of me weighted average cost of capital and conversely me total value of the firm. Thus, up to the degree of leverage, the use of debt will favorably affect me value of a firm, beyond mat point debt will adversely affect it. At mat level of debt-equity ratio, me capital structure is an capital structure. At the optimum capital structure, the marginal real cost of debt, include both implicit and explicit, will be equal to the real cost of equity. For a debt  ratio before that level, the marginal real cost of debt would be less than that of equity while capital beyond that level of leverage, the marginal real cost of debt would exceed equity.

There are, of course, variations to the Traditional Approach. According to one of these, the equity capitalization rate (k) rises only after a certain level of leverage and not before, so that the use of debt does not necessarily increase the k. This happens only after a certain degree of leverage. The implication is that a firm can reduce its cost of capital significantly with the initial use of leverage.

Another variant of the Traditional Approach suggest that there is no one single capital structure but, there is a range of capital structures in which the cost of capital is the minimum and the value of the firm is the maximum. In this range, changes in leverage have very little effect on the value of the firm.

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