Total Value and Cost of Capital (Traditional Approach)

It is clear that the optimal debt-equity ratio must be less than 2.67 since at this ratio, the value of the firm is Rs 2,75,000, while at a debt-equity ratio of 1.08 it is Rs,2,88,235. The traditional Approach suggests that:

Other things being equal, the market value of a company’s securities will rise as the amount of leverage (L) in its financial structure is increased from zero to some point determined by the capital market’s evaluation of the level of business uncertainty involved. Beyond this point and up to a second point, changes in leverage have very little effect, that is, within this range of leverage the total market value of the company is unchanged as leverage changes. Beyond this range of acceptable leverage the total market value of securities will decline with further increase in I.

The effect of increase in leverage from zero on cost of capital and valuation of the firm thought to involve three distinct phase.

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