Cost of capital is the cost of the capital structure of an organization. It consists of the cost of debt (interest paid on debt) and the cost of equity (returns paid to shareholders). In other words, it refers to the minimum rate of return that a company must earn to ensure that the market price of the shares of the company does not fall. The lower the cost of capital, the higher the value of the firm will be. Traditional Approach: According to this approach, the cost of capital of an organization depends upon the capital structure. By changing the debt-equity mix of the company, the cost of capital can also be altered.
Traditional theorists argue that the cost of capital decreases with an increase of debt in the debt-equity ratio as interest on debt is lower than dividends and interest on debt is tax-deductible. Let us illustrate this with the help of a graph. The lines for the cost of debt (ri) and the cost of equity (re) are now both drawn with an upward slope. The weighted-average cost of capital (WACC) first declines as cheaper debt is substituted for more expensive equity and then increases, swept up by the rising ri and re. The cost of capital reaches a low point, and the firm’s value reaches its maximum, in the middle of the graph.
Accordingly, the traditional approach concludes that the best debt-equity mix is somewhere in the middle, a function of the rate at which the risks perceived by investors increase. Modigliani-Miller Approach: This approach is based on certain assumptions namely- the existence of perfect competition, there are no taxes, investors can predict future earnings and the firm has a constant investment policy. According to this approach, the cost of capital is independent of the capital structure and the debt-equity ratio of the company. Modigliani and Miller argue that as debt increases, cost of capital does decrease.
However, investors expect higher returns for increased risk on account of increased debt and thus cost of capital also eventually increases, as depicted in the graph below. Comparison of Traditional and MM Approach: There are two major differences between the traditionalist view of corporate capital structure and the Modigliani-Miller view, the first difference lies in the traditional view’s contention that the value and cost of capital of a firm is interrelated to its capital structure, whereas the Modigliani-Miller view contends that they are independent of each other.
The second major difference is that the Modigliani-Miller view indicates a linear relationship between shareholder rate of return and firm leverage, which means that at low levels of debt the cost of equity increases faster under the Modigliani-Miller theorem than it does under the traditional view.
Although the Modigliani-Miller approach overcame many shortcomings of the Traditional approach, the Traditional Approach is, in my opinion, better. This is so because the Modigliani-Miller approach is based on many unrealistic assumptions such as perfect competition, no taxes, etc. Moreover, it is quite obvious that as the proportion of debt in the debt-equity ratio increases, cost of capital decreases, as debt is cheaper than equity.