TRADITIONAL APPROACH - Accounts and Finance for Managers

Traditional Approach in Financial Management

The traditional approach is known as intermediate approach in between the Net income approach and NOI approach. The value of the firm and the cost of capital are affected by the NI approach but the assumptions of the NOI approach are irrelevant. The cost of overall capital will come down due to the application cheaper source of financing viz Debt financing to some extent, after certain usage, the application of debt will enhance the financial risk of the firm, which will require the share holders to expect additional return nothing but is risk premium. The risk premium which is expected by the investors will enhance the overall cost of capital.

The optimum capital structure "the marginal real cost of debt, defined to include both implicit and explicit will be equal to the real cost of equity. For a debt-equity ratio before that level, the marginal cost of debt would be less than that of equity capital, while beyond that level of leverage, the marginal real cost of debt would exceed that of equity.

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