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350 Corporate Finance BRILLIANT’S

Q.36. According to the traditional approach, the manner in which the overall cost of capital
reacts to changes in capital structure can be divided in stages, what are the stages?
Q´>o{S>eZb EàmoM Ho$ AZwgma, {Og Vah H¡${nQ>b ñQ´>³Ma ‘| n[adV©Z Ho$ {bE ny§Or H$s g§nyU© à{V{H«$¶m hmoVr
h¡, Cgo ñQ>oOog ‘| {d^m{OV {H$¶m OmVm h¡, dh ñQ>oOog ³¶m h¢?

OR
Write a short note on traditional approach or intermediate approach.
Q´>o{S>eZb EàmoM ¶m B§Q>a‘r{S>EQ> EàmoM na EH$ g§{jßV ZmoQ> {b{IE&
Traditional Approach Q´>o{S>eZb EàmoM

The traditional view is also known as an Q´>o{S>eZb AdYmaUm H$mo "_Ü`_ AdYmaUm" ^r H$hm
'intermediate approach'. It is a compromise OmVm h¡Ÿ& `h ewÕ Am` H$s AdYmaUm d ZoQ> Am°naoqQ>J
between the Net Income Approach and the
H$m°ñQ> H$s AdYmaUm Ho$ _Ü` _mJ© H$mo Xem©Vr h¡Ÿ& Bg
Net Operating Approach. According to this
approach, the value of the firm can be increased AdYmaUm Ho$ AZwgma, S>oãQ> d Bp³dQ>r H¡${nQ>b Ho$ C{MV
or the cost of capital can be reduced by a proper {_lU go {H$gr \$_© H$s d¡ë`y H$mo ~‹T>m`m Om gH$Vm h¡ `m
mix of debt and equity capital. This approach H¡${nQ>b H$s H$m°ñQ> H$mo KQ>m`m Om gH$Vm h¡Ÿ& `h AàmoM
clearly indicates that the cost of capital de- ñnï>V: ~VmVr h¡ {H$ H¡${nQ>b H$s H$m°ñQ>, S>oãQ> H$s VH©$g§JV
creases within the reasonable limit of debt and
gr_m Ho$ A§VJ©V KQ>Vr h¡ Am¡a BgHo$ ~mX crdaoO Ho$ gmW
then increases with leverage. An optimum
capital structure exists when the cost of capi- ~‹T>Vr h¡Ÿ& O~ H¡${nQ>b H$s H$m°ñQ> H$‘ go H$_ hmo `m \$_©
tal is minimum or the value of the firm is H$s d¡ë`y A{YH$V_ hmo V~ Am°pßQ>__ H¡${nQ>c ñQ´>ŠMa
maximum. {dÚ_mZ hmoVm h¡Ÿ&
According to the traditional position, the Q´>o{S>eZb AdYmaUm Ho$ AZwgma, H¡${nQ>b ñQ´>ŠMa _|
manner in which the overall cost of capital n[adV©Z go H¡${nQ>b H$s H$m°ñQ> _| n[adV©Z Ho$ à^md H$mo
reacts to changes in capital structure can be
divided into 3 stages: {ZåZ{b{IV VrZ AdñWmAm| _| {d^m{OV {H$`m Om gH$Vm h¡Ÿ:
1. Increasing Value: In the first stage, the 1. _yë` _| d¥{Õ: àW_ AdñWm _| S>oãQ> _| d¥{Õ go
rate at which the shareholders capitalize their g_Vm A§eYm[a`m| Ho$ àË`m` _| ^r d¥{Õ hmoVr h¡ na§Vw Omo
net income remains constant or rises slightly
with debt. But when it increases it does not d¥{Õ hmoVr h¡ dh BVZr VoO J{V go Zht hmoVr h¡ {H$ bmo
increase fast enough to offset the advantage of H$m°ñQ> S>oãQ> Ho$ cm^ H$mo à{V-g§Vw{cV {H$`m Om gHo$Ÿ&
low-cost debt.
2. Optimum Value: Once the firm has 2. Am°pßQ>‘‘ d¡ë¶y: O~ \$_© _| brdaoO H$s _mÌm EH$
reached a certain degree of leverage, increase {ZpíMV ñVa na nhþ±M OmVr h¡ Vmo CgHo$ ~mX brdaoO _|
in leverage has a negligible effect on the value
d¥{Õ H$m \$_© H$s d¡ë`y `m \$_© H$s H¡${nQ>b H$s H$m°ñQ> na
or on the cost of capital of the firm. This is so
because the increase in the cost of equity offsets à^md ZJÊ` AWm©V² Zht Ho$ ~am~a n‹S>Vm h¡Ÿ& BgH$m H$maU
the advantage of low cost debt. At the specific `h h¡ {H$ S>oãQ> H$s bmo H$m°ñQ> Ho$ bm^ H$mo Bp³dQ>r H¡${nQ>b
point, the value of the firm will be maximum H$s ~‹T>r hþB© H$m°ñQ> g_m`mo{OV H$a XoVr h¡Ÿ& Bg {~ÝXw na \$_©
or the cost of capital will be minimum. H$s d¡ë`y A{YH$V_ `m H¡${nQ>b H$s H$m°ñQ> Ý`yZV_ŸhmoVr h¡Ÿ&