The theory of financial structure of the capital comprises the basic concept of financial management. It is closely connected with the theories of capital value and market value of the company, inasmuch as it is based on cost comparison attraction of own and borrowed capital and impact analysis of various combined financing options on the market value company. The stated interrelation conditions the development of these theories in a single conceptual complex.
The capital value index serves as an essential tool substantiation of managerial decisions focused on the rationality rise of capital formation and productivity of financial and economic activities of the company The valuation of capital cost in the in process of its formation is calculated in respect of both individual elements of own and borrowed capital, and their total. The index of weighted average cost of capital carries the data on the structure of its every unit and its investment into the outcome.
The theory of financial structure of the capital comprises the basic concept of financial management. Does the ratio of own and borrowed capital affect the market valuation? How does the the combination of capital units affect the value of its average cost? What proportion can provide maximization of company market value? Practically all of them are built on the study of emitted share ratio, which constitutes own capital, and loan stock, which constitutes borrowed capital.
The initial stage of theory development of financial capital structure is associated with the works of J. Williams on the valuation of financial assets, published in the 30-th of ХХ century and the later works of D. Duran. However, intensive research in this sphere started in the second half of 50–th with the publication of works of F. Modigliani and M. Miller, which significantly contributed into the development of modern approach to the analysis of financial capital structure. New (both complementary, and alternative) theories on the financial capital structure began to appear during the further development of financial theory and real corporative practice, as well as the generalization of empiric study results on the financial capital architecture of corporations. They determine modern approaches to its optimization.
Let us consider the evolution of theory of financial capital structure in terms of detection of their specific features, key merits and demerits. One of first theories of financial capital structure is a conventional theory, which originated before the appearance of works of F. Modigliani and M. Miller. It is based on the analysis of financial decisions. The peculiarity of indicated theory is the assumption on considerable dependence of average cost of company capital on its structure and possibility of optimization of capital structure based on the accounting of value of its constituents, and also on the fact that the value of borrowed capital of the company is always lower than its own capital. The latter is explained by the difference in risk level of use of borrowed and own capital on account of the following circumstances:
— predefined level of profitability of all forms of borrowed capital is conditioned by fixation of interest rates and repayment dates, contrary to own capital, which is characterized by stochasticity of expected return, and is formed under the conditions of uncertainty and connected with financial results of future periods at the indefiniteness of terms of attraction;
— obligation of support (in the form of security deposits, warranties etc.) at the attraction of borrowed capital;
— priority right of creditors on the return of committed facilities upon the liquidation of the company, in contrast to owners rights, receiving property on the residual principle.
Based upon the thesis on the lower value of borrowed capital contrary to own capital, the traditional theory comes to conclusion that the decrease of average company capital cost is achieved at the growth of gearing, which is the basis for its recommendation on the optimization of capital structure.
The advantage of the theory is, to our opinion, a position on the presence of interrelations between the financial capital structure, the capital cost and marketable value of enterprise (V). The specified interrelation is stated as follows.
where X- mathematical expectation of company earnings, expressed by the values of company earnings which are accidental and heterogeneous in time for the period t X(1), X(2), … X(t),
We – equity base, %
Wd – debt base, %
ke — equity value,
kd – debt capital value;
It really goes from the mentioned correspondence that at other equal conditions the maximization of market value index of the company is achieved at the index minimization of weighted average cost of capital. Besides, the provision of the traditional theory on a lower value of a borrowed company capital concerning the value of its own capital leads us to conclusion that the optimization of capital structure is achieved at the capital formation only at the expense of the borrowed money; the borrowed capital appears as a priority and single factor, determining the mechanism of such optimization.
Such conclusion contradicts the theoretic postulates and rules of thumb on the accounting of financial risk in the capital value. With the increase of debt in the overall capital structure of the company, the financial risk increases, which conditions the growth of margin cost of capital. In this regard, the maximization of leverage results in the loss of financial stability and bankruptcy risk. The above mentioned allows to conclude, that a traditional theory and a single-factor model structure of capital formation, built on its basis, are rather simplified and can hardly be used in practice.
In the year 1958 the theory of Modigliani-Miller (MM Theorem), was created, it was complemented with improved later. The theory originally received the name of the theory of capital structure indifference. Its essence lies in the provision that the optimization of financial structure of the company capital cannot be reached on the minimization criterion of weighted average cost of capital, or on the criterion of the market value of the company, because the financial capital structure does not have effect on these factors.
The peculiarity of the theory of indifference of financial capital structure is the research of mechanism of formation of capital structure in strong interrelation with the mechanism of capital market performance as a whole at the range of the following limitations and admissions:
— perfection of capital markets, which supposes complete competitiveness of the market, fullness and transparency of information for all its participants, rational character of their behavior, existence of uniform conditions of borrowings and investment, indistinction in the rate of interest for all investors and creditors, the action of single risk-free interest rate, absence of transaction costs, associated with the formation of separate elements and included into the calculation of their value;
— absence of profit taxation and income taxation of the owners of own and borrowed capital;
— stable development and absence of earnings growth (revenues from sales exclusive of the constant and variable expenses is equal to operational profit (EBIT), which value is constant);
— equality of own and stock capital (net profit is divided by dividends, and worn-out equipment is renovated at the expense of amortization expenses);
— the value of the borrowed capital is lower in comparison with own one;
— absence of so called «costs of bankruptcy» (risks, connected with the structure of capital units and conditioning the potential danger of loss of the part of assets during bankruptcy are not taken into account);
— determination of company market value on the unlimited time length as capitalization of operational profit.
On the basis of these conditions F. Modigliani and M. Miller proved mathematically, that the market value of the company, and correspondingly, the weighted average cost of the used capital, is defined only by the total value of its assets and does not depend on the financial capital structure. A formal proof of this position is built on the thesis that during the progress of company business activity its profitability generates not separate units of the capital, but its assets, and the analysis of arbitrage transactions (simultaneous purchase and sale of assets with different value identical in risk). On the perfect market, where as a result of parallel purchase by investors of shares from overrated companies and the investment of capital into shares of underrated companies, balancing of these prices takes place, the existence of companies similar in the degree of risk and size of operational profit, but with various market values, becomes impossible. Thus, in accordance with the model logic, market value of the company and weighted average cost of the capital are indifferent to the capital structure.
MM theorem is justified in conditions of the accepted limitations and admissions, which are far from reality of business behavior, and has a theoretic nature only. In addition, it states the set of conditions, at which the financial capital structure has no affects on the market value of the company.
F. Modigliani and M. Miller lifted a range of limitations in their further research (the model by application of tax, as well as the model by application of tax on the company profit and income taxation of the owners of stock and bonds), which would allow to make a conclusion on the presence of interconnection of the formation of company market value and the structure of its capital.
Compromise theory (the theory of static correlation), developed in the works of Brennan M., Schwartz E, Leland H. and other researches, supposes the accounting of such real economic conditions, as a factor of profit taxation and costs of bankruptcy.
Debt expenses in economic behavior of the majority of countries are subject to deduction wholly or partially from taxable base on the income tax. The value of borrowed capital at all other conditions being equal is always lower than the equity value at the expense effect of «tax shield». As a result, the growth of gearing in the overall structure of capital to the limits, not causing the growth of bankruptcy risk, leads to the decrease of weighted average cost of capital.
The bankruptcy risk, which is associated with the usage of various forms of borrowed assets at the formation of financial structure of business capital, is increases with the growth of debt. Let us admit, that one may distinguish direct and indirect expenses as a part of costs of bankruptcy. Direct expenses appear at the smashup of business, they include the reduction of asset salvage value because of moral and physical wear on the ground of persistence of lawsuits between the creditors of corporation, court costs, costs of lawyer and external manager etc. Indirect expenses appear before the declaration of enterprise in default, at the stage of financial difficulties; losses from ineffective financial decisions, from behavioral changes of creditors, customers, suppliers and other contractors are also referred there.
Thus, with the growth of bankruptcy threat of the company its creditor can either reduce the volume of provided borrowed capital, or require a higher level of income, in order to compensate the increased risk of loan default of borrowed money. In these cases it will lead to increase of weighted average cost of capital and reduction in market value of the enterprise. With the growth of debt the company value will increase thanks to tax savings (the effect of «tax shield»), however, with the onset of certain moment the growth of debt is accompanied by the decrease in the company value. The economic line of capital gearing for the company characterizes that level of value of the borrowed capital, at which the risk of bankruptcy, connected with it, covers the effect, secured by preferential tax terms. Thus, the optimization of financial structure of the capital is defined by correlation of benefits from tax shield and losses from the possible bankruptcy. As H. Leland states, that target value of financial capital structure can provide only preferential tax terms of debt and predicted costs of bankruptcy. The target capital structure should be set in such a way, that the marginal cost of capital and the marginal effect from financial leverage become equal.
The theory of static correlation determines the optimal target value of financial capital structure of the company by finding the compromise, which corresponds to the minimal value of weighted average cost of capital, taking account of two factors: profit taxation and costs of bankruptcy. In addition, it disregards the expenses of adaptation of the financial capital structure to optimal, economic behavior of managers, owners, other participants of economic process, as well as the range of other factors.
Meanwhile, if to take into account, for example, transaction costs, peculiar for recapitalization, it may turn out that when these expenses are too high for the companies, it will be more beneficial not to change the financial structure of the capital, even if it is not optimal within a specified time. E. Fischer, R. Heinkel, and J. Zechner J. in their empirical research studied the difference between the minimum and maximum level of company debt, and detected characteristics of companies with the extended variation of capital structure ranges without recapitalization and showed that the real and target capital structure can differ in consequence of adaptation expenses. The research results have confirmed the dilemma of financial capital structure using separate units of capital during the progress of their using separate item capital during the value assessment and their weighted average cost, not only capital service expenses, but also expenses on its attraction, which is transaction costs of recapitalization.
Further development of compromise theory is connected with the choice of type of the financial capital strategy (aggressive, moderate, conservative). Depending on the attitude of owners and managers of the company to the acceptable level of risk, the point of compromise can deviate from the minimum value of the weighted average cost, which reflects the specificity of financial decisions of the company within the risk/return trade-off. Modern compromise theory relies upon the acknowledgment of miltifactorial nature of financial capital structure, which defines the possibility of its dynamic choice.
Neoclassic conceptions (traditional, of Modigliani and Miller, of static correlation) suppose that financial decisions are accepted under the conditions of perfect market, where the information is full and available, but the economic behavior of participants is rational. Meanwhile, market prices do not reflect all information in the real world, the information is not transparent and popular for all its participants, which means that information is asymmetrical, but rationality of economic entities is limited.
Influence of information asymmetry on the optimization of financial capital structure is reflected in range conceptions, which proceed from the statement on the imperfection of genuinely functioning market and asymmetry of information for individual market participants on company’s expected future development. Asymmetry information conditions that various valuations of future rates of return and risks and, therefore, optimization of capital structure conditions. Thus, company managers usually possess more adequate information, in this regard, in comparison with investors and creditors, meaning the asymmetry of information. If the investors and creditors would possess the same information, as managers, they would be able to formulate their requirements to the expected rate of return of the company capital better, which would allow to optimize the capital structure in accordance with its real financial condition and development outlook.
These circumstances are taken into consideration in signal theories (Ross, Myers, Majluf, Miller, and Rock, Welch etc.) supposing that information asymmetry can be reduced based on certain signals for the creditors and investors, which are initiated by behavior of managers at the capital market.
One of the most famous signal models is considered a model of Myers – Majluf. It supposes, that managers act in the interests of shareholders, existing on the moment of decision making (so-called old shareholders), know the picture within company on the quality of capital investment project better than investors at the market. If investors have incorrect information of company evaluation, financing of efficient investment projects with the help of capital stock issues will make these projects unbeneficial for old shareholders, therefore for the purpose of realization of these projects it is better to use other financing sources, which price has less dependence on this company information (for example, profit or debt obligations).
Optimal strategies of capital raising are differentiated depending on the prospects growth of market prices on shares. In the presence of such perspectives, additional issue of shares will not allow to maximize the price of capital, and this source will secure maximum market estimation at their absence for the purpose of capital investment projects. At the information asymmetry the investors take into account these strategies in their decisions. Thus, if the company declares an additional issue, it is a signal of the fact that management considers the market price as overstated and the investor should lover the opinion on the valuation of corporation.
At the formation of purposeful financial capital structure the signal model recommends to consider the need of future capital mobilization with peculiar asymmetric information of such attraction and to support gearing at the level smaller than than meaning, at which marginal benefits of tax shields are equalized and marginal costs of bankruptcy according to the theory of static correlation. Thus, when taking decisions on the financial stricture of the capital the previous company development should be considered, as well as current and projected profitability of activity.
Based on the theory of debt (the year 1977) and the theory of capital structure at information asymmetry (the year 1984) S. Myers has substantiated the conclusions on the choice of financing sources by managers, which made the essence of theory on financing order (various sources call it as the theory of hierarchy and the «pecking order theory»). As S. Myers thinks that unappropriated profit occupies a preferential place among other sources of financing (inner source), then there is a borrowed capital, and then convertible bonds. Additional issue of shares is used in extremis, inasmuch as the market considers it as a negative signal.
The theory of financing order explains the circumstances, which cannot be interpreted within the theory of static correlation. As it was stated above, the announcement of additional issue of shares leads to the drop of prices on shares at the market because the investors lover their valuation of the company. It is unclear why the companies with high profitability in practice choose a low level of debt from positions of compromised approach, where it is supposed, that companies in one sector have the like structure (by virtue of uniformity assets, commercial risks, pricing, conditions of profitability and taxation). The theory of financing order allows to explain the stated paradox, because it is based on the fact that the expenses of adverse selection of investment projects can outbalance benefit and expenses, which are considered in the theory of static correlation. Besides because of the presence of high expenses on the issue of capital instruments (transaction costs and expenses of information asymmetry) the company sets a certain hierarchy of financing instruments. According to its logic, highly profitable companies have no need of attraction other, less preferred sources of financing.
Conclusions of the theory of financing order are confirmed by some empirical studies, where it is stated that more profitable companies will better produce debt, than capital stock. However, other empirical studies contain disproving evidence. Thus, according to results obtained by E. Fama and K. French, 86% of companies issued shares for the increase of capital over the period from 1983 to 2003. According to these scientists, such financial decisions are inconsistent with the theory of financing order.
The statement on information asymmetry also is within the basis of a range of conceptions of interests contradiction (agent theory, theory of corporate control and monitoring expenses, theory of stakeholders), as well as modern behavioral theories.
The first group of theories is focused on the accounting of contradictions of interests of various in members of business activity and valuation of admissible risks in the process of corporate governance and optimization of financial capital structure.
The conception of agency problem is fully stated in the classic work of M. Jensen and W. Meckling » Theory of the Firm: Governance, Residual Claims, and Organizational Forms», supposes that company management can take decisions, which may contradict to the interests of shareholders and creditors, corresponding; there is a necessity in the expenditures connected with tracking of its activity. The efficient instrument of agency problem solution is a correct selection of compensatory packet structure (share of participation, super dividends, share options), which allows to connect the profit of managers with the dynamics of equity value and secure motivation to its preservation and growth.
Agency costs of the own capital appear also in consequence of difference interests and information level of owners and creditors of the company. At the asymmetry of information, creditors, when furnishing capital, are interested in possibility of their own control over its efficiency of use and return. Expenditures, connected with monitoring, are generally transferred to the company holder by means of inclusion of its payment into the credit given. The level of monitoring expenses depends upon the rate of use of the company’s borrowed capital, that means that when the rate grows, the margin cost of capital increases and its market value decreases. Besides, the weighted average cost of capital can grow in consequence of agency debt costs. The latter are connected with the fact that shareholders, whose responsibility on partnership liabilities is limited to the share in company capital, can accept the investment strategies, able to maximize their welfare at the expense of debt holders. Thus, with the growth of debt for the purpose of investments with great risk or in cases, when partnership liabilities do not protect assets to the right degree, a part of risk is transferred to the creditor, however similar solutions decrease company market value.
The accounting of interests diversity of various parties at the capital structure optimization are the basis for stakeholders theory. Stakeholders are persons concerned, presented by inner and external interest groups, able to effect or be affected by on the part of the company. Basic stakeholders are: shareholders, institutional investors, managers of top echelon, employees, consumers, distributors, suppliers, financiers of corporation, representatives of state and municipal authorities, social and community groups. Diversity and intersection of interests of stakeholder, different valuation of their admissible risk cause conditions for the conflict of interests, which brings certain correctives in the process of optimization of financial capital structure.
Behavior theories (tracking of a market, autonomy of investments by managers, informational chains etc.), using the data on numerous empirical studies, try to describe the process of decision making on the capital structure formation in reality.
According to the market tracking theory the correlation of debt and capital is defined by a market dynamic. The term «market tracking» denotes practice of corporation to emit equity securities in the period of high prices at the market and to redeem shares in the period of low prices. Correspondingly, managers get benefits from temporary deviations of the equity value in reference to the value of other forms of capital. In conditions of market asymmetry according to D. Jenter, a subjective perception of managers on how the market evaluates shares is an essential factor in decision on the capital structure. As M. Baker and J. Wurgler J. state, «capital structure is formed because of attempt of management to control capital market and represents a sum total of all those attempts». Thus, market tracking and getting profit from current capital underestimation, or overestimation determine the financial capital structure, which is considered as optimal policy.
The managers investment autonomy theory develops statements of market tracking theory by establishment of links between decisions of managers on capital stock issues and their market value. However in contrast to the theory of market tracking, where the indicated link originates from overestimation or underestimation of the company, it testifies about the consent of investors with the activity of managers in this model. According to model logic, managers realize only those decisions, which are perceived by investors positively and, therefore, will have a positive impact on the company trade value: When the market-value of company shares and the degree of consent of managers and investors expectations are high, the company issues additional shares, and debt instruments in the opposite situation. Thus, financial capital structure is formed more under the influence of investors, whose expectations are considered by managers.
The basis for the theory of informational cascades, suggested by S. Bikhchandani, D. Hirshleifer, S. Welch., is imitative behavior of economic agents. The theory of informational cascades suggests, that financial capital structure can be formed not out of calculation of optimal structure or depending on the available company sources of financing in different age period, but be adopted from other companies with successful, authoritative managers (companies-leaders), and using (following the majority) the most popular methods of controlling the capital structure with a view to economy expenses and to ensure against errors.
Analyzing the evolution of theory of financial capital structure, researches suggest different classification s of existing theoretical approaches. Thus, T. Teplova specifies static theories, which suggest the search of optimal capital structure and its following, and dynamic capital structures, which admit the deviation from the target capital structure in the specific moment and defines the optimum as time series. I. Blank points at the incorrectness of such rendition, because, it appears to him, that a dynamism of target capital structure is defined not by the selected theoretical approach as methodological tools but as a dynamism of specific factors, considered by any theory of capital structure.
We agree with I. Blank that all theories take into account factors, determining the financial capital structure in this or that degree. The evolution vector of the theory of capital structure is connected with more and more such factors. Alongside with that, modern theories, in contrast to traditional ones, mainly explore the real structure of company capital, its correlation with the optimal structure, the process of adaptation of capital structure to the optimal one and its determinant. In this respect, they are based on the results of numerous empirical studies of company policy in the sphere of financial capital structure, according to which the latter is formed under the influence of various factors. We classify all these factors by their origin (factors of external and internal environment) and the nature of influence (institutional and legal, financial and economic, and social and administrative). See table 1.2.1.
Table1.2.1 – Factors, Defining the formation of financial structure of company capital
To our opinion, the basis of theory typology of financial capital structure should belong to their initial methodical principles. Thus, traditional theories rest on methodical principles of neoclassical approach: Perfection of market and rationality of market participants, while modern theories judge from imperfection of market, information asymmetry and inefficiency of economic agents, which are methodological principles, typical for institutional approaches to the analyses of economic processes. Taking into account stated above, the classification of basic theoretical approaches to the optimization of financial structure of company capital may be presented in the following manner (figure 1.2.1).
Figure 1.2.1 — Basic Theoretical Approaches to the Optimization of Financial Capital Structure of the Company.
The financial practice uses combinations of various theoretical approaches, taking into account inconsistency of various determinants at the establishment of a target capital structure. As it is stated in works, which summarize the results of economic researches, financial managers combine various theoretical models, considering the inconsistency of factors, which define the financial capital structure, and use their experience and intuition. As many researches think, it is necessary to take transitive characteristics in Russian conditions into account. It seals on the formation of factors, having an effect on the financial capital structure of national company.