Question

Explain the traditional, U-shaped approach to the cost of capital.

Short answer

Traditional financial theory states that there is a U-shaped cost-of-capital curve comparative with debt use by the organisation.

Step-by-step solution

Introduction to Cost of capital

Cost of capital addresses the return an organization needs to accomplish in order to justify the project of cost of a capital, for instance, constructing a new building or purchasing new equipment.

The traditional, U-shaped approach to the cost of capital

It is supposed that initially increase the debt-to-equity mix due to this the cost of capital will decrease. After reaching an optimum level, the increased use of debt will hike the overall cost of financing to the organisation. So it is said that the weighted average cost of capital curve is U-shaped.