## Traditional Approach

This approach holds that capital structure decisions ARE relevant. Through a proper mix of debt and equity, risk can be reduced and the value of the firm (VF) can be increased. It is studied in three phases.

### The Three Phases (as debt increases)

	Ke	Kd	Relationship	KO
Phase 1	Constant	Constant	Ke > Kd	Decreases
Phase 2	Increases	Constant	Ke > Kd	Constant
Phase 3	Increases	Increases	Ke > Kd	Increases

Phase 1: Cheap debt drives the overall cost of capital down.
Phase 2: Ke begins to rise to reflect added financial risk, offsetting the debt benefit — KO bottoms out and stays flat.
Phase 3: Both Ke and Kd now rise (lenders also demand more), pushing KO back up.

### Optimum Capital Structure

Occurs at the point where VF is highest and KO is lowest — i.e. at the bottom of the KO curve (around the end of Phase 1 / start of Phase 2).
The firm should aim to reach this optimal structure through a judicious use of both debt and equity.

### Main Highlight

The overall cost of capital is minimised and the value of the firm is maximised at the optimal capital structure.

⚠️ Common exam mistakes

Assuming KO falls indefinitely as debt rises — under the traditional view KO is U-shaped: it falls, flattens, then rises across the three phases.
Mislocating the optimum: it is where VF is maximum AND KO is minimum, not simply where debt is highest.
Forgetting that in all three phases Ke > Kd remains true.

Reference:

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Traditional Approach to Capital Structure

⚠️ Common exam mistakes