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CS Executive · Corporate Accounting and Financial Management · Capital Structure

Under the Traditional approach, as debt is added from zero, the overall cost of capital behaves as follows:

In the Traditional approach, the overall cost of capital first falls as moderate debt is introduced, stays near its minimum over a range, and then rises as excessive leverage pushes up both equity and debt costs. This gives an optimal capital structure.

  1. AIt remains constant throughout
  2. BIt rises continuously because equity cost rises
  3. CIt declines to a minimum point, remains roughly stable over a range, and then risesCorrect
  4. DIt falls continuously until debt is 100%

Explanation

Initially the cost of equity rises slowly, so cheaper debt reduces Ko. Over a moderate range the rise in equity cost roughly offsets the debt benefit, giving a minimum. Beyond that, both equity and debt costs rise sharply and Ko increases. This yields an optimal capital structure, unlike NOI (constant) or NI (continuous fall).

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