According to the traditional approach, what is the effect of increase in degree of leverage on the valuation of a firm? 

The correct answer is Increases first and then decreases Key Points 

•     Traditional theory of capital structure:
  • The traditional theory of capital structure says that for any company or investment there is an optimal mix of debt and equity financing that minimizes the WACC and maximizes value.
  • Under this theory, the optimal capital structure occurs where the marginal cost of debt is equal to the marginal cost of equity. 
  • This theory depends on assumptions that imply that the cost of either debt or equity financing vary with respect to the degree of leverage.
  • The traditional theory of capital structure says that a firm's value increases to a certain level of debt capital, after which it tends to remain constant and eventually begins to decrease if there is too much borrowing
  • In essence, the firm faces a trade-off between the value of increased leverage against the increasing costs of debt as borrowing costs rise to offset the increased value. Beyond this point, any additional debt will cause the market value and to increase the cost of capital