Financial Management Systems


Financial Management

Capital structure decisions

By Elina Panfilov

Spring semester 2014

It is significantly important for the company to identify the right proportion for the capital structure to make the company strong at the market and healthy. In this case, the key role takes capital structure decisions. It should be pointed out right at the beginning that the definition of capital structure is “a mix of a company’s long-term debt, specific short-term debt, common equity, and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds.” [1]


Selecting financing schemes is inextricably linked with taking into account peculiarities of using both own and borrowed capital. An enterprise that uses only equity has the highest financial stability, but it limits the pace of its development. This is due to the fact that the company cannot ensure the formation of the necessary additional amount of assets during periods of favorable market conditions. The result is that it does not implement financial growth opportunities for return on invested capital, which enables the use of borrowed capital.

A significant proportion of loans in the company’s capital structure caused by the effect of financial leverage. Its effect reflected in the fact that the company, which uses borrowed funds efficiently, has a higher return on equity. In this regard, in modern conditions managing of capital structure should be an important part of the financial policies of each company. The efficient capital structure allows achieving the desired profitability and liquidity of the enterprise while providing an acceptable level of financial risk.

Scientific Analysis

Analysis of scientific approaches to optimize the capital structure shows that at the basis the theoretical concepts of capital structure formation are contradictory approaches: the mutual independence of the capital structure and the market value of the enterprise to the direct interference.  In the first case, I mean the Modigliani-Miller Theorem, which tells that “under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.”[2] “The basic M&M proposition is based on the following key assumptions:

  • No taxes
  • No transaction costs
  • No bankruptcy costs
  • Equivalence in borrowing costs for both companies and investors
  • The symmetry of market information, meaning companies and investors have the same information
  • No effect of debt on a company’s earnings before interest and taxes” [3]

In the second case, I mean the Trade-Off theory of capital structure “tells us that we have to include debt in our capital structure only that limit or degree where we are capable to pay the cost of debt and also cost of bankruptcy cost of debt and bankruptcy cost of debt.” (Picture 1)[4]

Despite the fact that the existing theories of capital structure are internally consistent and logical within the limitations imposed on them, in practice it turns out that in all markets firms manage their capital structures , taking into account not only quantitative parameters proposed under each of scientific approaches , but taking into account a number of key quality factors influencing the formation of funding sources ( sales growth , stability, dynamics of turnover , profitability and dynamics , the existing structure and liquidity of assets , strategic orientation of the enterprise , taxation, capital market conditions ) .

Therefore optimization process involves setting the target capital structure, under which should be understood the ratio of debt and equity sources of venture capital, which gives full ensure the growth of the return on equity at an acceptable risk.

At the same time, the formation of target capital structure should be aimed at the solution of such problems as:

the formation of a sufficient amount of capital that provides the necessary economic development of the enterprise;

  • providing the conditions to achieve maximum return on capital at an acceptable level of financial risk;
  • ensuring the continued financial equilibrium of the enterprise during its development;
  • producing an adequate level of financial control over the company by its owners;
  • to provide sufficient financial flexibility of the enterprise;
  • optimization of capital turnover;
  • ensuring the timely meet the demand for investment resources.

The starting point for optimizing the capital structure of a particular company is to determine the total demand for capital to finance the necessary enterprise assets forming schemes of financing of current and non-current assets, the development of measures to attract various forms of capital envisaged sources. That is really the process of calculating the required amount of funds that can be used effectively at this stage of the life cycle of the enterprise. At this stage of the study cannot be realized without the opportunities most efficient use of capital in selected activities of the enterprise and business operations; formation proportions upcoming use of capital, ensuring the achievement of the most effective conditions for its functioning and growth of the market value of the enterprise.

The next step is to determine the amount of equity and debt that are available to the enterprise to finance its activities.

One of the first steps at this stage is to obtain and research the information about the most likely sources of funding as well as drawing up a list of possible ways to raise capital that the company can use as a source of funds for investment projects.

Each method of providing financial activities has limitations in its application that make exclude from inaccessible or not suitable for a variety of conditions and funding schemes that need to be considered when developing an optimal capital structure.

Further, by comparing the positive and negative characteristics of each of the potential sources as well as comparing the desired and available volume of funding sources, formed composition and capital structure.

The next step should be an assessment of compliance with the formed capital structure of the basic criteria that allow making a conclusion about its rationality. Such criteria should be considered as maximizing the market value of the enterprise, ensuring its financial sustainability, compliance with the capital structure of the enterprise’s assets structure, minimizing the weighted average cost of capital and an acceptable level of profitability. With these criteria in mind, it is necessary to define the target capital structure of the enterprise, ensuring maximum growth of enterprise value at acceptable risk. The decision to use these or other criteria should be taken within the selected financial policy of the company, based on its solved problems, management structure, the nature of long-term and operational planning and other factors.

Thereafter, the financial manager must make an assessment of compliance with formed structures of the company’s capital to the structure of its assets and the effect of the ratio of debt to equity on the financial condition of the enterprise through a system of financial indicators characterizing the liquidity, financial stability of the company, as well as the probability of bankruptcy. The purpose of this analysis is to determine the impact of formed capital structure on key financial ratios to assess the financial risk associated with the company, and the nature and quality of the assets financed by debt and equity sources. A financial manager can compare the calculated level of each ratio with its predicted value, taking into account the regulatory and industry average performance levels.

At the next justification stage of financial decisions it should be calculated the weighted average cost of capital to determine the required minimum return on invested capital in the company’s activity, to characterize the minimal level of net return on invested capital, which should have the company so as not to reduce the welfare of the owners and its market value without incurring loss and not go bankrupt.


Further, on the basis of this analysis, financial analysts have to make a final conclusion about the acceptability of risk and return that are associated with the proposed capital structure.

In case the all analyzed criteria, including the level of profitability and financial risk, and comply with strategy of the company and satisfy the owners of the company and Finance Directorate, this capital structure can be called optimal for these specific conditions. But if at this stage, the financial risk is recognized as unacceptably high, or, conversely, an acceptable level of risk means too high costs for capital raising, compared with the level of income generated by the enterprise, financial managers should review the capital structure to find a compromise between risk and return.



  4. org/2010/05/trade-off-theory-of-capital-structure.html”>
  5. Article “How to Make a Capital Structure Project” (steps) com/make-capital-structure-project-35732.html”>
  6. Article “The Optimal Use Of Financial Leverage In A Corporate Capital Structure”
  7. Article “Making Capital Structure Support Strategy” com/printable/article.cfm/5622276/c_2984411″>



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