11.11 The traditional approach to capital structure

Question 1

What is the “traditional” approach to capital structure?

Answer 1

An optimal capital structure is obtained by a blend of equity and debt financing that minimises WACC while maximising market value.

Question 2

What are the limitations of the “traditional” approach to capital structure?

Answer 2

• it does not quantify the effect of changes to gearing
• it ignores other real-world factors such as tax rates
• it assumes many factors such as : all profits will be paid as a dividend, there are no taxes, etc.