Final answer:
The traditional approach to capital structure suggests that increasing leverage beyond a certain point raises the cost of equity due to higher perceived financial risk. In an economy, capital deepening without technology improvements encounters diminishing returns, but technological advancements can ensure sustained growth. Business confidence and government borrowing also affect the demand for financial capital and interest rates.
Step-by-step explanation:
The question pertains to the traditional approach to capital structure and its impact on the cost of equity (ke) as leverage increases. According to this approach, there is an optimal range of debt-to-equity where the cost of capital is at its lowest; however, as leverage (use of debt financing) continues beyond a certain point, the cost of equity tends to increase at a faster rate. This is due partly to the increased financial risk perceived by investors as a company takes on more debt, potentially leading to higher expected returns (hence higher cost of equity) as they demand more compensation for the increased risk.
For instance, if an economy focuses solely on capital deepening (increasing the amount of capital per worker) without any improvements in technology, it would encounter diminishing marginal returns as it moves from a lower level of capital to a higher one. This is depicted by the transition from point R to point U to W, where each unit of additional capital adds less to the output per capita than the previous unit did. Improvements in technology, on the other hand, can shift the economy from point R to S to T, as seen in the Technology 1, 2, and 3 lines, respectively. This ensures that economic growth can continue without being hampered by the diminishing returns typical in capital deepening without technological progress.
Furthermore, factors like shifts in the demand for financial capital due to governmental borrowing or shifts in business confidence can affect the equilibrium interest rate and, consequently, the cost of capital. For example, a technology boom can increase business confidence and demand for financial capital, while an economic downturn can decrease this demand.