Management of capital structure
During the financial capital structure and realize their own value of leverage used now in the business.
In studying the structure of the company invested in property and funds necessary to distinguish between two concepts:
- The structure of financial sources that share in the total value of equity liabilities, long-term and short-term liabilities;
- Capital structure - the ratio between equity and debt, which include only long-term commitment.
From financial capital structure is largely dependent on the conditions of formation of financial results as return on assets, return on equity, the level of financial stability and solvency, the level of financial risk and ultimately the effectiveness of financial management in general. That is why financial capital structure is the subject of research of many scientists and economists.
Theory Miller - Modigliani (model M-M)
The impetus for the development of the theory of capital structure was the hypothesis put forward in 1958 by American economist F. Modigliani and M. Miller, whereby the capital structure does not affect the market value of the company. With these mathematical calculations, scientists have argued that if the financial liverydzhu by increasing the market value of debt, according to the same amount reduced price paid by owners of capital (capitalized earnings), and the total market value of the company changes.
Disadvantages model M-M (Miller - Modigliani) lies in the fact that it does not account for the increased risk with increasing leverage in the capital structure, unequal taxation of companies, as well as additional costs out of the crisis in times of financial recession activity.
Following the theory of capital structure made some amendments to the model M-M. The most famous of these theories is the theory of "static compromise," "subordination funding sources" and "asymmetric information".
This theory takes into account the costs of the company to exit from the crisis situation as a result of the financial downturn. Its essence is to reduce the value of the company with a significant increase in financial leverage shoulder. The more debt the firm, the greater the likelihood of financial turmoil, since the failure to pay debts on time lost liquidity, and the company is much harder to get a new loan to improve their financial condition. That is, the more the company uses borrowed capital, the higher the financial cost of borrowing and the possibility of lower capitalization of profits.
The theory of subordination funding sources (theory H. Donaldson)
In the early 60-ies of XX century. Gordon Donaldson has developed a number of provisions which are still governed by the financial managers of firms in substantiating capital structure. Shows the content:
- To reduce dependence on external sources of the company must first use internal sources of funding: income (after payment of financial obligations) and cushioning;
- Developing a dividend policy, to take into account future investment needs and cash flows of the company and thus distribute profits to shareholders to provide finance investment mainly from domestic sources (profit and depreciation)
- If there is a need for external sources of financing, it is advisable to follow this sequence: bank loans, issue bonds and conversion only in the last instance the issue of new shares.
The theory of asymmetric information (signal theory S. Mayer)
This theory emerged on the basis of a comparison of theories Miller - Modigliani and G. Donaldson. Its meaning is that financial managers whose decisions inform shareholders and potential investors about the situation and can actively influence the market price of shares of the company. So, if a company releases new shares, increasing investment, raises dividend, the price of its shares on the stock market increase. Conversely, when the company reduces the amount of dividends stops investing money in industrial development, attract additional external funding sources, the price of its shares on the stock market will certainly fall.
In addition to the above concepts, there are other theories. But despite such high interest of scientists to the problem of capital structure, in practice, found that no single optimal solution on the ratio of equity and debt, not only for the same type of business, but also for other businesses at different stages of development and with different conjuncture commodity and financial markets.
There are only a number of factors that must be considered when forming the target capital structure of the company to ensure the most effective prioritization between the level of return on equity ratio and autonomy.
Given these factors managing its capital structure the company should be carried out in two ways:
- Justification for the use of optimal proportions of equity and debt;
- Attracting the necessary volumes of equity and debt to achieve the target structure.
The optimal capital structure - it is the ratio between equity and debt, for which simultaneously ensures high financial profitability and financial stability is not lost business. It is clear that the greater the proportion of debt, so the greater the difference between the return on invested capital and the average interest rate on borrowings after tax effect will be more financial leverage (ie, increasing return on equity through the use of borrowed funds). However, financial liverydzh can be beneficial to a certain extent, because too much debt in the capital structure means that the company will not meet its fixed financial obligations. On the other hand, excessive issue of ordinary shares may lead to loss of control of the business owners.
Thus, extremes in managing its capital structure is very dangerous and can have devastating consequences.
To avoid them, financial managers should study the experience of the most successful companies in its field and try to maintain a balance between debt and equity. It is necessary to avoid anything as large debts for which payment of fixed obligations exceed the reasonable limit. To do this, each time deciding on new debt, calculate the worst situation (downturn, a sharp drop in demand for products or prices, appreciation loans, etc.) and find out whether the company fulfill its financial liabilities at fixed adverse operating conditions.
Thus, the purpose of financial management is to ensure a balanced capital structure that would meet the target company guidelines and ensures minimal financial risk for sufficiently high market value (not necessarily the highest).
Methods of study of financial decisions on the change in the capital structure and depends on the evaluation criteria. The criteria for optimizing the capital structure are:
- Minimizing the weighted average cost of capital;
- Maximizing return on equity while simultaneously minimizing risk;
- Maximization of net profit per share.
If the criterion of assessment to minimize the weighted average cost of capital, the best option is considered a capital structure that provides the lowest average cost of capital or least its marginal cost if additional funding.
In terms of maximizing the return on equity
the best is a combination of equity and debt, which is provided by the largest increase of return on equity due to the effect of financial leverage and thus the differential arm does not turn into a negative value.
The criterion of maximizing net income per share is mostly used when it is necessary to choose an alternative source of financing of assets, issue shares or issue bonds.
For a more accurate calculation should take into account the constant movement of shares and use their weighted average number. This takes into account all changes in the number of outstanding ordinary shares, including ordinary shares pay dividends, share splits, consolidation of shares, preferential issue of shares to existing shareholders and others.
Adjusted net income per share (or so-called diluted earnings per share) is calculated with the influence of ordinary shares:
- Bonds that are convertible into ordinary shares;
- Preferred shares that are convertible into ordinary shares;
- Warrants on shares;
- Share options;
- Actions that can be sold for special programs for employees;
- Contracts whose members have the right to receive ordinary shares based on the requirements stipulated in the contract.