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. For example, 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.