Traditional theory of traditional theory

Traditional theory, also known as compromise theory, is a theory between net income theory and net operating income theory.

The basic idea of traditional theory is that the cost of debt is generally less than the cost of equity because of the different tax reduction benefits and risks of debt. The cost of equity will increase with the increase of debt ratio, because the debt ratio increases, the risk increases, and the rate of return required by sovereign capital also increases. The cost of debt will only rise after the debt ratio has greatly increased. Moreover, when the debt begins to increase, the increase of the cost of equity can not completely offset the benefits brought by the debt, thus reducing the total cost of capital and improving the company's value. In this way, due to the use of debt, the comprehensive capital cost of enterprises will be moderately reduced. However, at a certain point, the increase of equity cost completely offsets and exceeds the benefits brought by the use of liabilities, and the comprehensive capital cost of enterprises begins to rise. Once the debt cost begins to increase, the comprehensive capital cost will further increase, thus reducing the enterprise value. The optimal capital structure is expressed by a certain point. At this time, the comprehensive capital cost of the enterprise is the lowest and the enterprise value is the highest. Therefore, the traditional theory holds that the capital cost of an enterprise depends on the capital structure, and there is an optimal capital structure.