This traditional theory approach advocated by financial experts Ezta Solomon and Fred Weston. It is also known as the Intermediate approach. The traditional approach to capital structure advocates that there is a right combination of equity and debt in the capital structure, at which the market value of a firm is maximum. As per this approach, debt should exist in the capital structure only up to a specific point, beyond which, any increase in leverage would result in the reduction in value of the firm.
It means that there exists an optimum value of debt to equity ratio at which the WACC is the lowest and the market value of the firm is the highest. Once the firm crosses that optimum value of debt to equity ratio, the cost of equity rises to give a detrimental effect to the WACC. Above the threshold, the WACC increases and market value of the firm starts a downward movement.
Assumptions of Traditional Approach
- The rate of interest on debt remains constant for a certain period and thereafter with an increase in leverage, it increases.
- The expected rate by equity shareholders remains constant or increase gradually. After that, the equity shareholders starts perceiving a financial risk and then from the optimal point and the expected rate increases speedily.
- As a result of the activity of rate of interest and expected rate of return, the WACC first decreases and then increases. The lowest point on the curve is optimal capital structure.
Modigliani-Miller (M-M) Approach
Modigliani and Miller presented rigorous challenge to the traditional view. This approach closely resembles with NOI approach. According to this approach, cost of capital and so also value of the firm remain unaffected by leverage employed by the firm.
Modigliani and Miller argued that any rational choice of debt and equity results in the same cost of capital under their assumptions and that there is no optimal mix of debt and equity financing.
The independence of cost of capital argument is based on the hypotheses that regardless of the effect of leverage on interest rates the equity capitalisation rate will rise by an amount sufficient to offset any possible savings from the use of low-cost debt.
They contend that cost of capital is equal to the capitalisation rate of a pure equity stream of income and the market value is ascertained by capitalizing its expected income at the appropriate discount rate for its risk class.
Thus, the essence of the M-M approach is that for firms in the same risk class the total value of the firm and the overall cost of capital are not dependent upon degree of financial leverage. The K and V remain constant for all degrees of financial leverage and value of the firm is found out by capitalizing the expected flow of operating income at a discount rate appropriate for its risk class.
assumptions of Modigliani and Miller
- (a) Personal and corporate leverage are perfect substitutes;
- (b) There does not exist transaction cost;
- (c) Rate of interest at which company and individuals could borrow is the same;
- (d) Institutional investors are free to deal in securities;
- (e) There are no taxes.
- (f) Borrowings are riskless.
- (g) Investors are fully knowledgeable and rational.
- (h) The firm’s investment schedule and cash flow are assumed to be constant and perpetual.