The Traditional Approach suggests that both the cost of debt and the cost of equity change as financial leverage increases. Initially, the cost of debt remains low, but it eventually rises, and the cost of equity increases as financial risk grows. Consequently, the Weighted Average Cost of Capital (WACC) is U-shaped, meaning it decreases to an optimal point and then increases. Therefore, none of these components remain constant.

The original M&M theorem (Proposition I) assumes a world without taxes. Therefore, the assumption that all firms pay tax at the same rate is inconsistent with the foundational M&M model, which relies on the absence of corporate taxes to prove that capital structure is irrelevant to firm value. Later versions of the theory introduced taxes, but the core M&M proposition is defined by the absence of tax distortions.

Overcapitalization is generally considered more dangerous because it implies that a company has more capital than it can profitably employ, leading to lower returns on investment and potential insolvency, whereas undercapitalization is often a sign of rapid growth or high efficiency.

The Net Operating Income (NOI) approach, proposed by David Durand, argues that the market value of a firm is determined by its operating income and the business risk, regardless of its capital structure. According to this view, the overall cost of capital remains constant as leverage changes, because the increase in the cost of equity exactly offsets the benefit of cheaper debt.

Capital structure refers to the specific mix of debt and equity used to finance a company's assets and operations. A firm may utilize various combinations, including common equity, preferred stock, and long-term debt instruments like debentures, to optimize its cost of capital and financial risk profile.

The indifference point is the level of EBIT where two different capital structures yield the same Earnings Per Share (EPS). If the expected EBIT is higher than this point, the plan with higher financial leverage (usually debt) will produce a higher EPS, making it the superior choice. Conversely, if EBIT is lower, the plan with lower leverage is preferred. Thus, one plan is mathematically better.

The Net Income (NI) approach, proposed by Durand, assumes that the cost of debt and the cost of equity remain constant as leverage increases. Because debt is typically cheaper than equity, this theory suggests that increasing the proportion of debt in the capital structure will decrease the overall weighted average cost of capital (WACC) and increase the total value of the firm.

Long-term assets like plant and equipment should be financed using long-term sources of capital to maintain the matching principle. Common stock equity provides permanent capital without the repayment pressure associated with debt, making it highly appropriate for funding capital-intensive investments that provide returns over many years, unlike short-term liabilities like trade credit or bank notes.

Debt financing provides a tax shield because interest payments are tax-deductible. The value of this shield is maximized when the corporate marginal tax rate is high, as it reduces the effective cost of debt. If the company has low non-interest tax benefits (like depreciation or tax credits), the interest tax shield becomes the primary mechanism for reducing taxable income, making debt more attractive.

The Traditional Approach suggests that the cost of capital is not constant and that a firm can minimize its overall cost of capital by finding an optimal mix of debt and equity. It argues that moderate use of leverage can increase the value of the firm, whereas excessive debt increases financial risk, thereby supporting the concept of judicious leverage usage.