Question 2 (a)
Traditional approach to capital structure
5 marks
- Time to write
- About 10 minutes
From an older CBCS paper
Question
Question 2 (a) · 5 marksUnder the traditional approach to capital structure, explain how the cost of debt, the cost of equity and the overall cost of capital behave.
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- ExplainEach point stated, then explained in a line or two.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 The approach as a compromise 1 mark 2 min
- 2 Behaviour of kd, ke and ko 3 marks 5 min
- 3 Optimal capital structure 1 mark 1 min
- Check: every ask answered, key terms underlined 1 min
Short on time? Step 2 carries 3 of the 5 marks: guard its minutes.
Try it first. About 10 minutes for 5 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
The approach. The traditional (intermediate) approach is a compromise between the net income and net operating income approaches: up to a point, more debt (a cheaper source than equity) lowers the cost of capital and raises the value of the firm; beyond that point the reverse happens.
How the three costs behave as leverage rises:
- Cost of debt (kd): constant up to a certain level of debt; thereafter it rises, as lenders see more financial risk.
- Cost of equity (ke): constant or rising only gradually at first; after a point shareholders perceive the financial risk and ke rises sharply.
- Overall cost of capital (ko): first falls, because cheap debt replaces costlier equity faster than ke rises; then stays roughly unchanged over a moderate range of debt; and finally rises, when the higher ke (and kd) can no longer be offset by the cheaper debt. The ko curve is therefore saucer- or U-shaped.
Is there an optimal capital structure? Yes. The lowest point of the ko curve is the optimal capital structure: there the overall cost of capital is minimum and the value of the firm is maximum. The firm should reach it through a judicious mix of debt and equity. This is what sets it apart from the NOI approach (and MM), under which capital structure is irrelevant and every mix is equally good.
Where the 5 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | The approach as a compromise | 1 |
| 2 | Behaviour of kd, ke and ko | 3 |
| 3 | Optimal capital structure | 1 |
| Total | 5 |
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