Traditional approach favors that as a result of financial leverage up to a certain level cost of capital comes down and value of the firm increases. However, beyond that level reserve trend emerges. Thus, the essence of the traditional approach lies in the fact that a firm through judicious use of debt-equity mix can increase its total value and thereby reduce its overall cost of capital. It is because debt is a cheaper source of funds as compared to raising money through shares because of tax advantage. However, raising debt beyond a certain point may become a financial risk and would result in higher equity capitalisation rate. The principal implication of traditional approach is that the cost of capital is independent on the capital structure and there is an optimal capital structure which minimises cost of capital. At the optimal capital structure the real marginal cost of debt and equity is the same. Before the optimal point the real marginal cost of debt is 19 less than real marginal cost of debt is more than the real marginal cost of equity and beyond this point the real marginal cost of debt is more than the real marginal cost equity. Therefore, the firm should strive to reach the optimal capital structure and its total valuation through a judicious use of the debt and equity capital in the capital structure. At the optimal capital structure the overall cost of capital will be minimum and the value of the firm is maximum. Illustration 14: In considering the most desirable capital structure for a company the following estimates of the cost of debt and equity capital (after tax) has been made at various levels of debt-equity mix. Debt as a percentage of total capital Employed Cost of Debt (%) Cost of Equity (%) 12.0 00 5.0 10 5.0 12.0 20 5.0 12.5 30 5.5 13.0 40 6.0 14.0 50 6.5 16.0 60 7.0 20.0 You are required to determine the optimal debt equity mix for the company by calculating composite cost of capital