The theory of financial management has dramatically changed the former notions on the management of corporate finances, mainly, in the reference to the strategic aim of its functioning, which is  the growth of the welfare of owners, providing the increase in  the market value of the company but not the  profit maximization. Accordingly, the optimal capital structure is such a combination of proprietory and borrowed capital, which provides the maximum market valuation of the whole capital.

 

 

The acknowledgment of the company value increase as its main strategic objective requires the development of the conceptual frameworks of the capital structure optimization in the system of total cost management. It is necessary to point out that, despite the presence of a large body of research in this sphere, there is no integral conception of the formation of optimal capital structure within the value approach to the corporate governance in economic literature.

 

The term “conception” (lat. conceptio) has a meaning of a master plan, which defines the strategy of actions at the implementation of reforms, projects, plans, programs; the frame of reference for the processes and events in the nature and in society according to the Contemporary economic dictionary[1]. The Great Soviet Encyclopedia uses the specified term for the identification of principal intentions, and a design concept in different types of activity[2].

 

The term “optimization” has a double meaning: the process of determining values of economical indicators, at which the optimum is reached, which is the best condition of the system, as well as the process of bringing of the system to the best (optimal) condition[3].

 

On the basis of the current conception of examined terms, the conception of the optimization of financial structure of the capital may be understood as the system of scientifically grounded and generalized practical experience on the opinions and objectives, which define the process of formation of the optimal financial structure of the capital in the system of the company’s total cost management

 

The fundamental point at the development of present conception is the correct identification of objectives, which determine the optimization of the process for the company capital structure. Notwithstanding that the theory of structure of the capital considers the growth of market value of the company as the objective optimality criterion; the economic literature and economic behaviour usually take various criteria into account.

 

Thus, I.A. Blank points out that the contemporary theories of the capital structure have a vast methodical tool of optimization of this factor at their disposal, at which the basic criteria are as following:

— maximization of the trade value of the company;

— minimization of the weighted average cost of the company capital;

— minimization of the level of financial risks in the activity of the company;

— maximization of the level of financial profitability.

 

Based on the determination of such criteria, I.A. Blank concludes that “the optimal capital structure refers to such a ratio of usage of proprietory and borrowed funds, at which the most efficient  proportionality between the financial earning capacity index and the financial stability index of the company is established, i.e. its market value is maximized”[4].

 

One may argue that it is possible to use the whole complex of indicated criteria at the structural optimization. We believe that the most accurate in this case is the position of M. Yenson, who stated that multiple objectives are their absence[5].

 

Indeed, it is logically impossible to maximize simultaneously in more than one dimension, unless these dimensions are in the direct proportion. The object-orientated formation of the capital structure requires the existence of a clear objective function. The objective and the priority of the optimization criterion of the company capital structure is the maximization of its market value.

 

It should be pointed out that the foreign theory of capital structure in the Russian financial practice and various alternative models have application mainly for the analysis of liability structure with the primary objective for the provision of financial stability but not the maximization of market value of the company. Some researchers consider such models as not applicable in Russian conditions, where the capital market is almost absent, and, therefore, it is impossible to speak about the market value of the company, the maximization of which is the objective for the analysis of the capital structure[6].

 

We suppose that the reforming of financial system in Russia, which is mainly touched upon the company finances as its basic fundamental unit, the realignment of ownership rights during privatization process, development of financial market institutions and other processes, which accompany the market reconstruction of the Russian economy, condition the necessity of active implementation of modern models in the capital structure formation and the development  of the value approach to the corporate governance — Value Based Management (VBM) into the economic life of the company.

 

The basic principles of VBM may be defined as follows:

 

— the value maximizing of the company is the key factor of the company performance efficiency and the top target of strategic management, which supposes the objective formation and system definition of key factors for the creation of value

 

— the money flows and capital value, which is invested into assets for the generation of these flows play the leading role in the system of key factors for the creation of value.

 

At the same time, at the implementation of VBM, it is necessary to take into account, that the value approach, like any other approach to the company management, is the definite model of social realm. The comparative effectiveness of the model, concerning the available alternatives, is defined by its efficiency to explain and forecast the corresponding economic processes.

 

The world practice has demonstratively proved the advantages of choice in the company market value as the priority criterion of its activity results and are based upon the value approach in comparison with the alternative modes:

 

— the increase of value for the shareholders does not contradict with the long-term interests of other interested parties and the society as a whole, as the shareholders are the permanent claimants upon the flow of money of the companies. The residual equity undertakes the maximum risk, but it itself conjugates the partnership rights in the corporate governance. Strong impulses stimulate the shareholders to maximize their requirements;

 

— the assessment of the market value requires the fullest data on the operation of the company;

 

— market value, as contrasted with the value, based on the accounting reporting, allows to take all expenses into account (including the alternative costs), risks of the company operation, as well as the time factor;

 

— the value approach makes it possible to combine long-term and short-term objectives of the company development in the optimal way by means of development of quantitative indicators, which rest upon the key value drivers, build integrated management control system of the company, which is based on the clear structure hierarchy of indicated factors, as well as to expand the «agent problem» by means of creation of  the system of material consideration, which is directly «pegged” to the dynamics value (evaluation, planning and control of the key value drivers in «the area of responsibility» of the corporate employees).

 

The criteria of value are not absolutely perfect. But, as M. Yenson indicates, for now there is no other criterion, which is equal in ability to reflect a great variety of various factors in the single criterion, upon which the company future may depend[7]. In this respect the criterion of value stands down both as the factors of absolute financial result of business operation (clean profit, inclusive of the accounted for one share), and the relative factors (return on the assets, investments, shareholders’ funds etc.). Such indicators, which are built on the index of the accounting income, characterize the latest activity of the company and slightly correlate with the market value. Such statement is proved a posteriori. According to calculations of professional consultants, engaged into the valuation, the correlation index of profit and company value makes not more than 8%[8]. According to the T. Coupland data, changes of the profit for the share do not affect their value[9].

 

Meanwhile the problem of optimization of the capital structure is often decided based on the search of such correlation of proprietory and borrowed capital of the company in economic literature and financial practice, at which the desired values of normal financial coefficients are reached: financial leverage, earnings per share, return on equity etc. (table 1.3.1). I. Ivashkovskaya, at the systematizing the optimization of the capital structure of the  company, names such approach as accounting one, opposing it to the financial approach, based on the usage of indicators, and connected with the investment risk (weighted average cost of the capital)[10].

 

One of the methods within the accounting approach, described by I. Ivashkovskaya, is a method of operating profit, directed to the determination of the allowable level of debt in the capital structure by means of detection of the likelihood of business smashup on the ground of the assessment of the volatility of its profit.

 

 

Table 1.3.1 – Financial coefficient, used at the optimization of the capital structure of the company.

 

Name

Symbol

Arithmetic formula

1.

Financial leverage ratio

 FL 

     Borrowed capital_ Proprietory capital

2.

Effect of financial leverage(according to American model)

  DFL

Earning before interest and taxes  Earning before interest and taxes – interests — dividend on the preferred stocks 

3.

Earnings per share

EPS

Net profit — dividends on the preferred stocksCommon shares outstanding

4.

Return on equity

 ROE

________Net income________Average annual balance sheet valueof proprietory capital

  Bankruptcy is thus regarded in the simple form — as inability of the company to perform regular payments on its debts. Other assumptions of the present method are connected with the character of distribution of income receivable and the assumption on its independence from the level of leverage ratio. Taking into account these assumptions, a statistical factor is calculated, which allows to describe the likelihood of bankruptcy depending on the amount of the debt used, which is compared with a certain initially preset threshold, received on the grounds of the expert evaluation. If the likelihood of bankruptcy at this size of debt is lower than the imposed restriction, then the debt financing should be increased, and vice versa, if the likelihood of bankruptcy is above the threshold, then the debt level should be reduced. The targeted amount of debt is reached when the likelihood of bankruptcy is equal to the predetermined threshold value.[11].

 

Observing the disadvantages of the present method (usage of historic significance of profit, not accounting the indirect bankruptcy costs etc.), I. Ivashkovskaya points out that the method of operational profit is completely applicable as one of the elements of the complex approach to the optimization model of the capital structure, and it is also very convenient as far as the express methods and the preliminary appraisals of the capital structure are concerned.

 

Another method of formation of the optimal capital structure is the method EBIT-EРS, which is described by T.V. Teplova in particular. The search of correlation of the borrowed and proprietory funds, wherein the company value is the highest, is carried out coming from the assumption about the direct dependence of the profitability from the risk.

 

The optimal capital structure, which corresponds to the existing balance of interests in the house, is the one, at which the maximum level of net income per share at the minimal financial risk is reached, which is characterized by the level of financial leverage — the risk of transformation of earnings before interest and taxes (EBIT) into the net income (EРS). The situation when the level of net income per share is achieved at the minimal financial risk, is characterized by the achievement of the point of indifference, at which the value of EBIT ponds to the maximal value of EРS at the minimal value of financial risk, which means that the net income per share is the same both with the attraction of the borrowed funds and without, when only proprietory funds are used. In this case the return on assets of the company is equal to the average rate interest at the open market. If the company increases the net income per share at the expense of additional attraction of proprietory funds only, the production risk increases (the risk of transformation of marginal profit into the before-tax profits and interests), which can be increased without increasing of the fixed charges until the certain limit is reached. On the other hand, the size of net income per share may be increased by means of attraction of additional capital on the account of proprietory and borrowed funds in certain ratio. The mechanism of financial leverage is used for the conduction of optimization calculations.

 

At the determination of importance of the analyzed methods for the financial decisions they all have a common disadvantage, which is focused on the indices of the previous activity of the company, and consequently, the weak correlation with the index of enterprise value.

 

The optimization of capital structure according to minimization criterion of the weighted average cost of the capital (within the financial approach) has no such disadvantage. However, the minimization of weighted average cost of capital cannot come out  as an optimality criterion of its structure by itself. The analysis of provisions of the examined theories of the capital structure testifies that the business capital should consist of the borrowed funds only at such approach, the value of which is always less than the stock capital at other equal conditions; but this means the loss of financial stability and the threat of business smashup.

 

It is necessary to indicate that at the reduction of cost of capital the company value will grow up only when the change of capital structure does not render the negative influence on the flow of money. If the decrease of the acceptable level of risk takes place as a result of procurement of a new borrowed capital and this leads to the subsequent reduction of the money flows, the company value may decrease even at the reduction of the capital value. Meanwhile, the objective of financial management is the maximization of the company value, instead of the cost minimization for the capital.

 

Thus, the growth of the market value acts as a valid economic criterion, which reflects the integral effect of the impact of the decisions made on all characteristics, on which the activity of the enterprise is estimated (market share and stability of competitive positions, incomes, investment requirements, operating efficiency, taxation load, regulation, and, finally, the money flow and risk level, which allows to range the variants in the situation with the multiple choice). The effectiveness of management of the capital structure formation is achieved at the presence of such an objective criterion only.

 

The establishment of optimal capital structure requires an application of not only the quantitative evaluation, but also the qualitative analysis of the particular set of external and internal factors, which condition the present structure. The resulting impact of such a set of factors defines the correlation of profitability, risk and liquidity parameters, provided at the formation of financial structure of the company capital.

 

Taking into account the stated above, the optimal financial structure of the company capital is such a correlation of all forms of proprietory and borrowed capital, at which the maximization of the substantiated market value of the company is achieved, taking into account the required balance “profitability — risk — liquidity”.

 

The optimization process of the capital financial structure is built on the certain principles. Contemporary economic literature on the problem considers mainly the principles of the capital formation rather than the optimization of its structure. This is explained by the fact that the process of capital formation includes the actions on the optimization of its structure as the most important constituent. The analysis of works, the authors of which pay special attention to the principles of capital formation [12], allows to define the following basic principles:

 

— accounting of prospects for the development of economic operations of enterprises;

— provision of correspondence of the attracted capital volume to the volume of formed assets of the enterprise;

— provision of the optimality of capital structure with the aim of the efficient use;

— provision of cost minimization on the capital formation from different sources;

— provision of the efficient use of capital in the process of business activity.

 

Some researchers also refer the stated principles to the formation of the capital structure of the organization[13], which is rather arguable to our mind. We consider the principles of the optimization of capital financial structure to have specific contents, and therefore they should be specified.

 

The principles (lat. principium means the basis, the beginning) mean the basic initial provisions of some theory, basic rules of activity; settled, rooted, generally accepted, and widely used rules of economic activity and character of economic processes.[14].

 

On this basis, the principles of formation of optimal financial capital structure refer to as the fundamental rules, which lie on its base and which should be observed at the making of corresponding financial decisions (picture 1.3).

 

One of the basic principles of the formation of optimal financial structure of the capital is the principle of scientific and practical substantiation. The relevant choice of objective characteristics of the financial capital structure, taking into account the present-day development of the financial theory and practice, and based on the results of the analysis of influence of the external and internal factors of the capital structure, allows to make decisions, which promote the efficient company development.

 

 

 

Picture 1.3.1 – Formation principles of the optimal capital structure of the company.[15].

 

The problem of optimization is always connected with the formulation of the objective and the choice of the optimization criterion of its achievement. It is impossible to speak about the optimization without its conditions and defined optimality criteria. In accordance with the mathematical description, the optimization suggests the achievement of the extreme (maximum or minimum) of the objective function at the set restrictions. Concerning the optimization of the financial capital, as it was shown, such objective criteria is the maximization of the company value. Therefore, one of the key principles of the formation of optimal financial structure of the capital is the principle of purposefulness, which means the orientation on the maximization of this factor.

 

Maximization of substantiated market value of the company must be reached under the predetermined correlation of “earning power — risk — liquidity” within the accepted financial policy (aggressive, moderate, conservative). Meanwhile, the given characteristics have a multidirectional nature, thus presupposing the necessity of their balancing for the achievement of the primary objective by means of formation of the vector of concomitant objectives (sub objectives). Accounting of correlation “profitability — risk – liquidity” is thus an important principle of formation of the optimal financial capital structure.

 

Another principle of formation of financial capital structure is the financial flexibility. It supposes the ability of the company to take into account the transformation of external and internal factors dynamically, react on the current changes both long-term and short-term adequately. Thus the process of formation of the optimal capital structure is the process of adoption of the current capital structure to the real conditions, allowing to take the new determinants into account.

 

Efficiency is also referred to the principle of formation of the financial capital structure. The exact contents of the notion “efficiency”, as G.B. Kleiner defines, depends on the peculiarity of economics, where the efficiency of the adopted or ruling paradigm is studied, the objective of the investigation, points of view and many other factors and conditions[16]. The analysis testifies that the determination of efficiency from the economic literature is mainly based on the notion about functioning of economic system as a chain «expenses – results – objectives (functions)» despite the existing differences” and supposes the opportunity to measure or estimate the expenses, results, and objectives [17]. Besides, the notion “efficiency” is considered as the basic principle of activity and the loyal vector of movement to get the end result, providing the achievement of the set objective with minimal expenses; as well as the characteristics of productivity activity, measuring the received effect with the use of expenses (recourses) for this.

 

We have the first rendition of this notion applicable to the task of our research. The efficiency of formation of the optimal financial capital structure means the opportunity to achieve the set objective characteristics at the rational usage of opportunities and resources, which are already at the disposal.

 

The optimization process of financial structure of the capital in the system of management of the company value should be carried out taking into account the interrelation of strategic objective, accompanying subgoals, depending on its achievements and factors of value creation.

 

The factors of creation of the value characterize the activity, upon which the result of the strategy of value growth depends[18]. It is a multilevel system, which exhibits its dependence upon the factors of higher level and shows, how the index value is related to the current activity. Therefore, the value management actually means the management of the system of value factors. Large companies may include various factors into the system, which management requires a lot of expenses. Therefore the primary task is to define the key and the most important factors, which should hold all the efforts on the value management.

 

Financial structure of the company capital refers to such key factors, which defines the importance of its optimization in the system of company value management. The process of formation of the optimal financial structure of the company capital is subject to the tasks for the provision of its efficient activity not only in prospect, but also in the running period; therefore it should be viewed in the strategic and current aspects.

 

The strategic objective of business activity of the company is the maximization of its substantiated market value, which conditions the objective orientation of the financial capital structure, as mentioned above. However, the current period should define the accompanying subgoals, the vector of which is related to the implementation of strategic objective.

 

The previous statement defined that the conventional financial characteristics, which are based on the financial income (net income, earnings per share, return on assets, return on equity), do not correlate fully with the market value index. This defines the necessity to establish the indicator, which should meet the given requirements. 

 

Such indicator can be found if to take into account that the index of market value allows to combine the long-term and short-term objectives of the company activity by means of  combination of the indices of value and economic profit, created in the company for the current period of time, for example a month, quarter, or year. The index value, built in respect to the principle of economic income, is defined by such a circumstance, that it can settle the contradiction between the bookkeeping and financial approach, as well as to formulate the limitations and assumptions, necessary for the implementation of the optimum of correlation of proprietory and borrowed capital, taking into account the system balance “profitability – risk — liquidity”.

 

Contrary to the accounting income, the utilization value of not only interest charges on the borrowed funds, but on all elements of the capital employed, is taken into consideration at the making up of economic income. That way the economic income serves as a criterion of the efficient use of capital. Its positive value indicates the growth of property asset (net assets) and means that the company has earned more than it is necessary to cover the value of utilize resources.[19].

 

The approach to the conflict resolution on the levels of profitability, risk, and liquidity can be presented in general in the following way. As it was stated above, with the increase of gearing in the overall structure of the capital, the profitability grows, but together with the financial risk, and in case of capital gearing on the short-term basis the current liquidity decreases. Thus, the growth of liquidity comes into conflict with the factors of financial risk and current liquidity. The settlement of examined contradiction is reached by special relation between the growth rate of economic profit (EP), borrowed funds (Е) and current assets (CА). This condition of optimization of the financial structure of the company capital can be presented as in the equation:

 

                           ∆ EP > ∆ CА  > ∆ Е                                     (1.2) 

 

At the fulfillment of the condition the exceeding of profit over the value of the utilize resources, the decrease in the risk of business solvency loss and the achievement of supportable level of liquidity are provided.

 

The growth of economic income reflects the process of creating the value in the running period, thus securing the succession of long-term and short-term objectives on the formation of the financial capital structure under the system of total cost management in the company.

The presented conceptual approach, in our opinion, can be taken as the basis for the development of current optimization of the financial capital structure and the creation of the corresponding model.

 

 

 



[1] B.A. Raizberg, L.Sh. Lozovsky, Ye.B. Starodubtseva. Contemporary Economic Dictionary./Райзберг Б. А., Лозовский Л. Ш., Стародубцева Е. Б. Современный экономический словарь. 5-е изд., перераб. и доп. — М.: ИНФРА-М, 2007.

 

[2] Great Soviet encyclopedia /Большая советская энциклопедия. — М: 1985. – С. с.94.

 

[3] B.A. Raizberg, L.Sh. Lozovsky, Ye.B. Starodubtseva. Contemporary Economic Dictionary./Райзберг Б. А., Лозовский Л. Ш., Стародубцева Е. Б. Современный экономический словарь. 5-е изд., перераб. и доп. — М.: ИНФРА-М, 2007.

 

[4] I.A. Blank /Бланк И.А. Management of Capital Formation. — К.: «Ника-Центр», 2000. — С.213-214.

 

[5] Jensen M. Value Maximization, Stakeholder Theory, and the Corporate Objective Function. The Monitor Group and Harvard Business School. — 2001.

 

[6] O.V. Sevostyanova The Effectiveness of Combination of Proprietory and Borrowed Means for the Development of the Industrial Production. Dissertation Abstract /Севостьянова О.В. Эффективность сочетания собственных и привлеченных средств для развития промышленного производства. Автореферат диссертации на соискание ученой степени кандидата экономических наук. — Казань, 2007.

 

[7] Jensen M. Value Maximization, Stakeholder Theory, and the Corporate Objective Function. -The Monitor Group and Harvard Business School. — 2001.

 

[8] T.G. Loznev  Value management – is a Modern Theory of Strategic Management of the Company Value / Лознев Т.Г. Стоимостной менеджмент – современная теория стратегического управления стоимостью компании // Сибирская финансовая школа. — 2006. — №2. — С.15.

 

[9] T. Coupland, T. Coller, J. Murrin Company Value. Valuation and Management /Коупленд  Т., Коллер  Т., Муррин Дж. Стоимость компаний. Оценка и управление. — 3-е изд., перераб. и доп. — М.: «Олимп-Бизнес», 2005.

 

[10] I Ivashkovskaya И. From the financial leverage to the optimization of capital structure of the company / Ивашковская И. От финансового рычага к оптимизации структуры капитала компании // Управление компанией. — 2004. — № 11.

 

[11] I. Ivashkovskaya Management of the Company Value as a New Vector of the Financial Analysts of the Company /Ивашковская И. Управление стоимостью компании — новый вектор финансовой аналитики фирмы // Управление компанией. — 2004.  — № 5.

[12] I.A. Blank Management of Capital Formation. / Бланк И.А. Управление формирование капитала. — К.: «Ника-Центр», 2000; Ковалев В.В. Финансовый менеджмент. — М.: Финансы и статистика, 2002. T.V. Teplova Financial Management: Management of Capital and Investments etc./ Теплова Т.В. Финансовый менеджмент: управление капиталом и инвестициями и др.- М.: ГУ ВШ, 2001.

 

[13] O.V. Sevostyanova The Effectiveness of Combination of Proprietary and Borrowed Means for the Development of the Industrial Production. Dissertation Abstract /Севостьянова О.В. Эффективность сочетания собственных и привлеченных средств для развития промышленного производства. Автореферат диссертации на соискание ученой степени кандидата экономических наук. — Казань, 2007. — С. 10.

 

[14] B.A. Raizberg, L.Sh. Lozovsky, Ye.B. Starodubtseva. Contemporary Economic Dictionary./Райзберг Б. А., Лозовский Л. Ш., Стародубцева Е. Б. Современный экономический словарь. 5-е изд., перераб. и доп. — М.: ИНФРА-М, 2007.

 

[15] Is made by the author according to the research materials.

 

[16] G.B. Kleiner The Effectiveness of Mesoeconomic Systems of the Transition Period / Клейнер Г.Б. Эффективность мезоэкономических систем переходного периода // Проблемы теории и практики управления.

 

[17] P. Drucker Effective Management/ Друкер П. Эффективное управление. — М.: Изд-во Гранд, 2003. — С.54; K. McConnell, S. Brew Economix: Principles, Problems, and Politics / Макконнелл К., Брю С. Экономикс: Принципы, проблемы и политика. — М., 2007.- Т. 1. — С. 39;  Problems of Efficiency in Contemporary Science/ed. By A.D. Ursula/ Проблема  эффективности в современной науке / Под ред. А.Д.Урсула. — Кишинев, 1985. — С.119;  .V. Kovalyev Financial Analysis: Methods and Procedures /Ковалев В.В.Финансовый анализ: методы и процедуры. — М.: Финансы и статистика, 2002;  D. Khan Planning and Control: controlling conception / Хан Д.Планирование и контроль: концепция контроллинга. — М.: Финансы и статистика, 1997. — С.56 и др.

 

[18] T.G. Loznev  Value management – is a Modern Theory of Strategic Management of the Company Value / Лознев Т.Г. Стоимостной менеджмент – современная теория стратегического управления стоимостью компании // Сибирская финансовая школа. — 2006. — №2. — С.14.

 

[19] V.D. Novodvorsky, N.V. Klestova, A.V. Shpak Business Profits: Bookkeeping and Economic /Новодворский В.Д., Клестова Н.В., Шпак А.В. Прибыль предприятия: бухгалтерская и экономическая // Финансы. — 2003. — №4. — С.64-66.