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CS Executive · Corporate Accounting and Financial Management · Capital Structure

The traditional approach to capital structure holds that:

The traditional approach says that moderate use of debt lowers the overall cost of capital, but beyond a point rising financial risk raises it. So an optimal capital structure exists where the overall cost of capital is minimum and firm value maximum.

  1. ACost of capital is lowest at 100% debt
  2. BCost of capital is unaffected by leverage at all levels
  3. CAn optimal capital structure exists where overall cost of capital is minimumCorrect
  4. DCost of equity falls as debt rises

Explanation

The traditional view says Ko falls initially as cheaper debt is added, stays about flat, then rises as Ke and Kd increase with financial risk. The minimum point of the U-shaped curve gives the optimal structure.

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