What is the 'Traditional Theory Of Capital Structure'

The Traditional Theory of Capital Structure states that when the Weighted Average Cost of Capital (WACC) is minimized, and the market value of assets is maximized, an optimal structure of capital exists. This is achieved by utilizing a mix of both equity and debt capital. The Traditional Theory of Capital Structure says that a firm's value increases to a certain level of debt capital, after which it tends to remain constant and eventually begins to decrease if there is too much borrowing. This decrease in value after the debt tipping point happens because of overleveraging. A blend of equity and debt financing can lead to a firm's optimal capital structure.

BREAKING DOWN 'Traditional Theory Of Capital Structure'

The Traditional Theory of Capital structure tells us that wealth is not just created through investments in assets that yield a positive return on investment; purchasing those assets with an optimal blend of equity and debt is just as important. Several assumptions are at work when this theory is employed, such as, there are only debt and equity financing available for the firm; the firm pays all of its earnings as a dividend; the firm's total assets and revenues are fixed and do not change; the firm's financing is fixed and does not change; investors behave rationally; and there are no taxes. Based on this list of assumptions it is probably easy to see why there are several critics.

The traditional theory can be contrasted with the Modigliani and Miller (MM) theory which argues that other forces will indicate the optimal capital structure of a firm, such as corporate tax rates.

RELATED TERMS
  1. Optimal Capital Structure

    An optimal capital structure is the mix of debt, preferred stock and common ...
  2. Capital Structure

    Capital structure is how a firm funds its operations and growth, ...
  3. Capitalization Structure

    Capitalization structure refers to the proportion of debt and ...
  4. Cost of Capital

    Cost of capital is the required return necessary to make a capital ...
  5. Accelerator Theory

    The accelerator theory is an economic theory whereby as demand ...
  6. Theory of the Firm

    The theory of the firm is the microeconomic concept founded in ...
Related Articles
  1. Investing

    Seven Controversial Investing Theories

    Find out information about seven controversial investing theories that attempt to explain and influence the market as well as the actions of investors.
  2. Investing

    Target Corp: WACC Analysis (TGT)

    Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
  3. Investing

    The Optimal Use Of Financial Leverage In A Corporate Capital Structure

    The amount of debt and equity that makes up a company's capital structure has many risk and return implications.
  4. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  5. Investing

    Modern Portfolio Theory Vs. Behavioral Finance

    Or: How financial markets would work in an ideal world vs. how they work in the real world.
  6. Investing

    McDonald's Stock: Capital Structure Analysis (MCD)

    Learn about the importance of capital structure, and what equity and debt capitalization measures can tell us about the performance of McDonald's Corporation.
  7. Investing

    Evaluating a Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
  8. Investing

    Lowe's Stock: Capital Structure Analysis (LOW)

    Examine Lowe's Companies' equity capitalization, debt capitalization and enterprise value to analyze trends in the retailer's capital structure.
RELATED FAQS
  1. How do bankruptcy costs affect a company's capital structure?

    Understand the Modigliani and Miller theory of capital structure. Learn how the theory shows how bankruptcy costs affect ... Read Answer >>
  2. What are the benefits and shortfalls of the Herfindahl-Hirschman Index?

    Learn about the differences between equity and debt financing and how they impact financials. Find out how businesses determine ... Read Answer >>
  3. How does a company choose between debt and equity in its capital structure?

    Learn about the benefits and drawbacks of debt and equity financing. Find out how to compare capital structures using cost ... Read Answer >>
  4. How does a company's capitalization structure affect its profitability?

    Learn about capitalization structure and how the combination of debt and equity a company uses to fund operations can affect ... Read Answer >>
  5. What's the difference between agency theory and stakeholder theory?

    Learn how agency theory and stakeholder theory are used in business to understand common business communication problems ... Read Answer >>
  6. What is the chaos theory?

    The chaos theory is a complicated and disputed mathematical theory that seeks to explain the effect of seemingly insignificant ... Read Answer >>
Hot Definitions
  1. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  2. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  3. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  4. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  5. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  6. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
Trading Center