Q. Show the Phase of Traditional Approach?

Phase of Traditional Approach: According to the traditional approach the way in which the overall cost of capital and the value of the firm react to changes in the degree of financial leverage is able to be divided into three stages:

(1) First Stage: - In the first stage raise in financial leverage that is the use of increased debt in the capital structure results in reduce in the overall cost of capital (k_o) and increase in the value of the firm. This is for the reason that a relatively cheaper source of funds debt replaces a relatively costlier source of funds equity. In this stage cost of equity (k_e) and cost of debt (k_d) remains constant.

(2) Second Stage: - Once the firm has reached a convinced degree of financial leverage increase in leverage doesn't affect the overall cost of capital and the value of the firm. This for the reason that the increase in the cost of equity because of added financial risk completely offsets the advantage of using cheaper debt. In that range the overall cost of capital will be least and the value of the firm will be utmost. This range represents best capital structure.

(3) Third Stage: - In the third stage the further raise in debt will lead to increase in overall cost of capital and will reduce the value of the firm. This happens because of two factors:

(i) Owing to improved financial risk K_e will rise sharply and

(ii) K_d would as well rise because the lenders will as well raise the rate of interest as they may require compensation for higher risk.

Figure illustrates that cost of equity (k_e) increases negligibly in the initial stage but starts rising sharply in the later stage. Cost of debt stays constant up to a certain degree of leverage and thereafter it also starts rising. The whole cost of capital (k_o) curve is saucer-shaper with a horizontal range RR. The most favourable capital structure of the firm is represented by range RR because in this stage the overall cost of capital (k_o) is minimum and the value of firm is maximum.