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      Question

      A company is evaluating its debt-equity mix. It observes

      that increasing debt reduces overall cost of capital up to a point, but beyond that the cost of equity rises sharply due to higher risk. Which theory of capital structure does this situation best represent?
      A Net Income Approach Correct Answer Incorrect Answer
      B Net Operating Income Approach Correct Answer Incorrect Answer
      C Traditional Approach (Intermediate Theory) Correct Answer Incorrect Answer
      D Modigliani-Miller Approach without Taxes Correct Answer Incorrect Answer
      E Pecking Order Theory Correct Answer Incorrect Answer

      Solution

      The Traditional Approach suggests an optimal capital structure exists where WACC is minimum. Beyond that point, cost of equity rises disproportionately due to financial risk.

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