Traditional Theory of Capital Structure - Explained
What is the Traditional Theory of Capital Structure?
Written by J. Mance Gordon
Updated at April 22nd, 2024
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What is the Traditional Theory Of Capital Structure?
The Traditional Theory of Capital Structure is a theory that posits that for an optimal capital structure to exist, the weighted average cost of capital (WACC) must be at a minimum level while the market value of the assets or company is at the maximum level. An optimal capital structure is also regarded as an optimal debt to equity ratio in this traditional theory. The traditional theory of capital structure maintains that the capital structure of a company ( a mix of debt and equity capital) is an important metric in gauging the value of the company. However, an optimal structure of capital exists when the overall cost of capital of the firm is reduced and the market value of the firm or its assets maximized.
How Does the Traditional Theory Of Capital Structure Work?
According to the traditional theory of capital structure, the optimal capital structure will increase to a certain level before it remains constant and eventually begins to decrease. More borrowings, debts and higher demand for return by equity holders can cause the optimal capital structure to decline. An increase or a cline on the optimal structure of capital affects the value of a firm. Hence, when the overall cost of capital is reduced up to a specific level of debt, the optimal capital structure exists thereby increasing the value of a company.