Question 9.S-TQ10: Briefly explain the traditional view of capital structure.

The traditional theory of capital structure proposes that an optimal capital exists, and so under this theory a company can increase its total value by the sensible use of gearing. The traditional theory argues that:

– K_e rises with increased gearing due to the increasing financial and bankruptcy risk;

– K_d rises only at high gearing levels when bankruptcy risk increases;

– replacing more expensive equity finance with less expensive debt finance decreases the company’s WACC, up to a point;

– once an optimum level of gearing is reached, K_e increases by a rate which more than offsets the effect of using cheaper debt, and so the WACC increases.