The traditional view, which is also known as an intermediate approach, is a compromise between the net income approach and the net operating approach. According to this view, the value of the firm can be increased or the cost of capital can be reduced by a judicious mix of debt and equity capital. This approach very clearly implies that the cost of capital decreases within the reasonable limit of debt and then increases with leverage. Thus, an optimum capital structure exists, and it occurs when the cost of capital is minimum or the value of the firm is maximum. The cost of capital declines with leverage because debt capital is cheaper than equity capital within reasonable, or acceptable, limit of debt. The statement that debt funds are cheaper than equity funds carries the clear implication that the cost of debt, plus the increased cost of equity, together on a weighted basis, will be less than the cost of equity which existed on equity before debt financing. In other words, the weighted average cost of capital will decrease with the use of debt.
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