The Traditional Approach to Capital Structure

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The traditional approach to capital structure
The traditional approach stresses the benefits of using the combination of cheaper debt and equity finance to find the optimal capital structure, so the total value of firms will be increased with the sensible debt. (Watson and Head, 2013) Of cause, the model was created which based on a certain assumption 1) There is no tax at a personal or a corporate level. 2) The perpetual debt finance and ordinary equity shares are the financial choices for firms. 3) The capital structure can be changed without incurring issue or redemption costs. 4) Any debt finance is up or down, which will lead to the same situation in equity finance. 5) All distributable earnings will be regarded as dividends by companies. 6) The relative business risks of companies keep existing over time. 7) The earnings and dividends of a company will not be increased over time.
To understand this traditional approach in depth, the theory model is illustrate in figure 1.

(Watson and Head, 2013)
As the figure showed, the cost of equity curve (k_e) is presenting a rising trend with the increasing gearing because of the growing level of financial risks of shareholders. The steeper rate of curve (k_e) at the higher level of gearing which embodies that the investment value of shareholders is being threatened by the risk of company bankruptcy. It can be seen that the cost of debt (K_d) is not increasing until at level of gearing. Hence the bankruptcy risks also threat to the debt holders. The point A stands for the company began to use the cheaper debt finance instead of the expensive equity, it will lead to the lower weight average cost of capital (WACC) initially. When t...

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Under the condition of asymmetry information, if the outsides investors obtaining the information about the enterprise asset value is less than the corporate managers’, the market value of rights and interests of the company won’t get an accurate pricing. When the company shares are undervalued, managers prefer to choose other financing ways to raise the money such as internal financial or issue bonds. In the case of stock value is overvalued. The Managers will try to secondary offerings to reduce the investment risks.

Reference:
Hiller.D. Ross.S and Jordan.B, (2013) Corporate Finance, (2nd edn), UK: McGraw-Hill Education.
Pike,R. Neale.B, and Linsley.P( 2012) Corporate Finance and Investment,(7 edn), London: Pearson Education Limited.
Watson.D and Head.A, (2013) Corporate Finance Principles and Practice, (6 edn), UK: Pearson Education Limited.

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