Optimization of structure of owned and loan capital

Economic sciences/3. Financial relations

student Germakhanov Sh.A., teacher Romanyuk V.B.

Tomsk State University, Russia

Optimization of structure of owned and loan capital

Growth of any social and economic system shows up in growth of goods and services offered by business entities. However this objective tendency of firm to overturn or sales volume build-up generally demands additional capital formation. In its turn attracted additional capital joined to disposable firm capital forms a new correlation of firm funding sources. This combination of debt and owned capital that each time should equilibrate with firm assets is called a capital structure.

The capital structure is often defined in a narrower sense as a proportion in which firm uses owned and long term borrowed resources. Difference of these wordings is in debt content. On the presumption that short term obligations are equilibrated by short term assets, then subtracting these quantities from both parts of balance equation, we come to the second definition of the capital structure.

In principle it is not so important for understanding the essence of the capital structure which of these wordings is more exact and objective, although as it will be shown later this difference is not always can be ignored.

The capital structure of firm forms under the influence of many factors, both internal and external. The more material effect is exerted by rates of growth of firm overturn; heaviness of tax burden; menace of firm take-over. If this menace is evident then as protection against take-over the firm piles up a debt part in the capital structure because this piles up expenses of its take-over; state of capital market. The broader the capital availability in the open market, the more chances has the firm to form an optimal capital structure for itself; firm assets structure. Firm availability of highly liquid assets and assets of universal use (cars, autocranes and others) simplifies receipt of borrowed funds and at the same time keeping a low risk level of illiquidity; new scaled projects financing requirement; level and behavior of firm profitability.

In the theory of finances a set of tools for capital structure management is used, but financial and operation levers take a special place. The financial lever is an instrument of owned and loan capital proportions control with the purpose of maximizing the efficiency of own funds. Its action appears in the financial lever effect (FLE) which means an increase of own funds efficiency that can be reached owing to use of borrowed funds despite of their payment of interest and recurrency. The financial lever effect is reached provided that an economic efficiency of firm assets (EE) is higher than average lending interest rate (ALIR). Difference between economic efficiency of assets and average rate of interest in the open market adjusted for tax allocations value is known as differential of financial lever (D), i.e. :

D = (1 - TRP) ∙ (EE - ALIR)

TRP - Tax rate of profit

Differential is a basis of financial lever effect growth. But financial lever force is also important which is measured by financial lever «arm» (A), value of which is determined by correlation of borrowed and owned funds of firm or by its capital structure, i.e.:

A = BF / OF

Then the level of financial lever effect is equal to:

FLE = D · A

Thus general formula of calculation of financial lever effect is the following:

FLE = (1 - TRP) ∙ (EE - ALIR) - (BF / OF)

It is not difficult to see that if a firm uses only its own funds then their profitability (POF) is equal to:

POF = (1 - TRP) ∙ EE

If a firm uses borrowed and its own funds, then:

POF = (1 - TRP) ∙ EE +(-) FLE

It is obvious that a sign FLE is determined by a sign of differential of financial lever. The point is that under certain conditions a positive sign of differential can be changed into an opposite sign, when ALIR < EE. It happens when trying to reinforce financial lever by means of its «arm» growth. But the greater the «arm» is, the higher financial risk is, and the higher risk is, the higher ALIR is. If ALIR exceeds EE, then differential will take a negative sign. Apparently differential sign change takes place in a point when D = 0, i.e. in a crisis point. These reasonings made financiers arrive at a conclusion that financial lever effect is a measure of level of financial risk.

Thus financial lever is a powerful tool of capital structure management. But it should be used prudently to the maximum otherwise all its might can be turned into its opposite – destructive power.

Let us investigate this question by the example of OJSC «Tomskneft». At a table 1 there is a company’s capital structure in the last 2 years.

Table 1. – Structure of owned and loan capital of OJSC «Tomskneft»

Name of criterion	01.01. 2005		01.01.2006
	ths RUB	%	ths RUB	%
Owned capital	11 350	76,3	19 484	79,9
Loan capital	3 733	24,7	4 912	20,1
Total	15 084	100	24 397	100

Company’s loan capital share dropped in 2006 in comparison with 2005 in 4,6 per cents, that positively affected the improvement of financial responsibility and creditworthiness of the company. In order to answer the question of practicability of attraction of borrowed funding sources and at what interest we calculate financial lever effect (table 2).

Table 2. - Calculation of financial lever effect for OJSC «Tomskneft»

Criterion	Symbol	Period		Forecast 2007
Criterion	Symbol	base 2005	reporting 2006	Forecast 2007
Differential	D	0,03	0,05	0,7
Financial lever «arm»	A	0,32	0,25	0,28
Financial lever effect	FLE	0,009	0,13	0,19
Owned funds, ths RUB	OF	11 350	19 484	22 750
Borrowed and attracted funds	BF	3 733	4 912	6 113
Tax rate of profit, in shares	TRP	0,24	0,24	0,24
Average lending interest rate, in shares	ALIR	0,12	0,12	0,12
Economic efficiency of assets, in shares	EE	0,16	0,19	0,22

Calculations show that the attracted assets have produced the result to some extent as economic efficiency has grown in comparison with the preceding year. The owned assets are growing from year to year whereas the loan capital is growing also, but concerning the owned capital it is dropping greatly. OJSC «Tomskneft» can attract borrowed funds, even when raising lending interest rate slightly.

Bibliography:

1. Balabanov I.T. Basis of financial management. М.: Finances and statistics, 2003.

2. Belolipetskiy V.G. Firm finances. М.: Infra-M, 2004.

3. Stoyanova E.S. Financial management. М.: Perspektiva, 2003.

Criterion