## Traditional Approach

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 a compromise between the NI and NOI approaches.

### The Three Phases

Phase 1 — Judicious use of debt (K₀ falling)

K_e and K_d remain constant; K_e > K_d.
K₀ decreases as debt is introduced (cheap debt pulls down the average).

Phase 2 — Optimum range (K₀ at minimum)

K_e rises (equity holders start sensing risk).
K_d remains constant; K_e > K_d.
K₀ remains constant (the rise in K_e just offsets the cheap debt).

Phase 3 — Over-leveraged (K₀ rising)

K_e rises further and K_d also rises (lenders now sense higher risk).
K_e > K_d.
K₀ increases — adding more debt now destroys value.

### Optimum Capital Structure

The optimum capital structure occurs at the point where the value of the firm is highest and the cost of capital (K₀) is lowest — this lies at the bottom of the U-shaped K₀ curve (within/at the end of Phase 2).

### Main Highlight

The firm should reach its optimal structure through the judicious use of BOTH debt and equity. At that optimum, the overall cost of capital is minimum and the value of the firm is maximum.

### Graphical View

K₀ traces a U-shape (saucer-shaped curve): falling in Phase 1, flat/minimum in Phase 2, rising in Phase 3.

Worked example

### Example 1

Locating the optimum across debt levels. A firm computes K₀ at different debt proportions: \n- 0% debt → K₀ = 12.0% \n- 20% debt → K₀ = 11.2% (Phase 1, falling) \n- 40% debt → K₀ = 10.8% (approaching minimum) \n- 50% debt → K₀ = 10.8% (Phase 2, flat minimum) \n- 70% debt → K₀ = 11.5% (Phase 3, rising). \nOptimum: around 40–50% debt where K₀ is minimised (10.8%) and VF is maximised. Beyond this, K₀ rises and value falls.

### Example 2

Phase identification. If increasing debt causes ONLY K_e to rise while K_d and K₀ stay put → the firm is in Phase 2 (optimum zone). If a further increase makes BOTH K_e and K_d rise so that K₀ climbs → the firm has crossed into Phase 3 and is over-leveraged.

⚠️ Common exam mistakes

Thinking K₀ falls indefinitely with more debt (that is the NI view) — under the Traditional approach K₀ is U-shaped and eventually RISES in Phase 3.
Believing the optimum is at 100% debt — the optimum is at the MINIMUM of the U-shaped K₀ curve, a moderate debt level, not maximum debt.
Forgetting that in Phase 3 BOTH K_e and K_d rise — many students keep K_d constant throughout.
Confusing the optimum criterion — it is the point of MINIMUM K₀ and MAXIMUM VF (the two coincide).

Reference:

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