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CA Intermediate · Financial Management and Strategic Management · Financing Decisions - Capital Structure

Under the traditional theory of capital structure, which statement describes the behaviour of the overall cost of capital (Ko) as leverage is increased from zero?

In the traditional theory, the overall cost of capital first falls as cheap debt is added, then stays roughly flat over a range, and finally rises as financial risk raises both equity and debt costs, giving an optimal capital structure.

  1. AKo falls to a minimum, stays roughly flat over a range, and then risesCorrect
  2. BKo rises continuously from the start
  3. CKo falls continuously with every additional rupee of debt
  4. DKo stays constant at all levels of leverage

Explanation

The traditional view holds an optimal capital structure exists. Initially cheaper debt lowers Ko; then there is a flat range; beyond that, higher Ke and Kd due to financial risk push Ko up. Continuous fall is the Net Income approach; constant Ko is the Net Operating Income approach.

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