Question 3 OR (a)
Traditional approach: costs of debt and equity and the overall cost of capital
9 marks
- Time to write
- About 18 minutes
Question
Question 3 OR (a) · 9 marksWhat happens, under the Traditional Approach to capital structure, to the cost of debt and the cost of equity as leverage increases? Describe how the overall cost of capital behaves.
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
- What…?Describe…Two asks in one question: answer both.
What the paper leaves open
No marks are printed against this part; it carries 9, with part (b), from the question's 18.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Behaviour of the cost of debt 2 marks 4 min
- 2 Behaviour of the cost of equity 2 marks 3 min
- 3 Behaviour of ko through the three stages; optimum 5 marks 9 min
- Check: every ask answered, key terms underlined 1 min
Short on time? Trim steps 1–3 evenly rather than skip one: each is capped at its own marks.
Try it first. About 18 minutes for 9 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 traditional (intermediate) approach is a compromise between the net income and net operating income approaches. As leverage increases:
Cost of debt (kd). It stays roughly constant over moderate levels of debt, since lenders see little extra risk. At high leverage, lenders see more financial risk and kd also rises.
Cost of equity (ke). Up to a point it rises only slowly. Beyond that point the increased debt raises the financial risk of the equity shareholders and ke rises sharply.
Behaviour of the overall cost of capital (ko)
- Stage 1 (moderate debt): debt is cheaper than equity and ke rises only a little, so the advantage of cheap debt dominates: ko falls and the value of the firm rises.
- Stage 2 (optimum range): the rise in ke offsets the benefit of cheaper debt; ko is at its lowest and roughly constant over this range, and the firm's value is highest.
- Stage 3 (heavy debt): the rise in ke, and now in kd too, more than offsets the advantage of debt: ko rises and the value of the firm falls.
So ko traces a U-shaped (saucer-shaped) curve, and there is an optimum capital structure, a point or range of leverage at which ko is minimum. The firm benefits from a moderate, judicious use of debt.
Where the 9 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Behaviour of the cost of debt | 2 |
| 2 | Behaviour of the cost of equity | 2 |
| 3 | Behaviour of ko through the three stages; optimum | 5 |
| Total | 9 |
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