Traditional Theory of Capital Structure

What Is the Traditional Theory of Capital Structure?

The traditional theory of capital structure states that when the weighted average cost of capital (WACC) is minimized, and the market value of assets is maximized, an optimal structure of capital exists. This is achieved by utilizing a mix of both equity and debt capital. This point occurs where the marginal cost of debt and the marginal cost of equity are equated, and any other mix of debt and equity financing where the two are not equated allows an opportunity to increase firm value by increasing or decreasing the firm’s leverage. 

Understanding the Traditional Theory of Capital Structure

The traditional theory of capital structure says that a firm's value increases to a certain level of debt capital, after which it tends to remain constant and eventually begins to decrease if there is too much borrowing. This decrease in value after the debt tipping point happens because of overleveraging. On the other hand, a company with zero leverage will have a WACC equal to its cost of equity financing and can reduce its WACC by adding debt up to the point where the marginal cost of debt equals the marginal cost of equity financing. In essence, the firm faces a trade-off between the value of increased leverage against the increasing costs of debt as borrowing costs rise to offset the increase value. Beyond this point, any additional debt will cause the market value and to increase the cost of capital. A blend of equity and debt financing can lead to a firm's optimal capital structure.

The traditional theory of capital structure tells us that wealth is not just created through investments in assets that yield a positive return on investment; purchasing those assets with an optimal blend of equity and debt is just as important. Several assumptions are at work when this theory is employed, which together imply that the cost of capital depends upon the degree of leverage. For example, there are only debt and equity financing available for the firm, the firm pays all of its earnings as a dividend, the firm's total assets and revenues are fixed and do not change, the firm's financing is fixed and does not change, investors behave rationally, and there are no taxes. Based on this list of assumptions, it is probably easy to see why there are several critics.

The traditional theory can be contrasted with the Modigliani and Miller (MM) theory, which argues that if financial markets are efficient, then debt and equity finance will be essentially interchangeable and that other forces will indicate the optimal capital structure of a firm, such as corporate tax rates and tax deductibility of interest payments.