Capital is understood as the total value that can be used to obtain added value by organizing production and economic activities.
It also represents the total amount of financial, material resources that are used to obtain benefits in the form of profit.
In simpler words, capital is the totality of all the means that an enterprise has to create goods and products in order to profit from their sale.
Structure concept
Under the structure in the general sense understand the relationship, the interdependence of the constituent parts (elements). It represents the way the firm finances its activities.
In economics, this definition should be understood as the ratio between borrowed and own funds of the company.
The development of the company depends entirely on the established capital structure. With a rational organization, the company is guaranteed success and profitability, with an irrational one - financial losses, bankruptcy,debt addiction. Therefore, the issue of forming a rational capital structure for an enterprise is very important.
Own and borrowed funds
When studying the concept of structure, it is necessary to consider the essence of own and borrowed capital.
Under the company's own cash fund is understood all of its assets that can be used to create part of the property and belong to it by right of ownership. Components of equity:
- statutory - contributions from the founders of the business at its opening;
- additional - funds of the founders in addition to the authorized, the amount of revaluation of property based on the results of changes in its value;
- reserve capital - part of the funds allocated from the amount of profit for the formation of reserves to cover possible losses;
- retained earnings: retained by the company after taxes and dividend payments.
To borrowed funds are funds taken by the company from other organizations on certain conditions under contracts or agreements. These finances are considered attracted on the basis of their return under the terms and conditions of the contract. These include:
- bank loans;
- bond loans.
Issues of structure optimization
In this situation, optimization should be understood as the formation of a rational relationship between the parts. With regard to the capital structure, we can say that it is necessary to form a rational relationship between own andthe firm's borrowed money fund.
For the formation of the optimal capital structure, it is impossible to give a clear recommendation, since the situation of each firm is individual. However, in any case, the company needs to achieve such a ratio in which the share of own funds is 60% of the total amount. If this value is exceeded, we can say that, in principle, the picture is favorable for the company, since it does not depend on creditors, but the return on capital in such a situation decreases.
Therefore, raising additional debt capital in the form of a 40% share can provide the company with the opportunity to develop production, open new lines, and as a result, receive additional profit.
In this regard, the use of borrowed funds in enterprises should not be rejected, especially in the event of a lack of own funds for the development of the company in the future. However, the standard for this attraction is limited to 40% of the total amount of capital. If it is exceeded, the company becomes dependent on creditors, which will invariably lead to bankruptcy and a financial crisis.
Therefore, the formation of the structure of the main savings of the company is a complex process that requires a careful approach and assessment by the financial component.
Price and capital structure
These two definitions are closely related concepts.
The concept of the value of the main fund has almost always been the basic one in financial calculations. The cost of capital can characterize the level of profitabilityinvested cash condition, which is a necessary condition for the formation of high market productivity of the company.
The cost of capital determines the cost of resources. An increase in the value of a company is always characterized by a decrease in the cost of the resources it attracts. The cost of capital is also used to make investment decisions about investing in the development of the firm.
Research on the value of the main fund has the following objectives:
- analysis of the formation of the policy of providing working capital with finances;
- possibility to use leasing instruments;
- profit budgeting.
The price of capital can be formed under the influence of the following factors:
- market conditions;
- interest rate;
- availability of different sources of funding;
- indicators of profitability of the company;
- operating lever and its level;
- Equity concentration;
- shares of operating and investment activities of the firm;
- financial risks and their assessment;
- features of the functioning of the company in the industry.
Sequence of calculations
The price of a firm's capital can be determined in the following sequence of steps:
- determination of the main sources on the basis of which the capital of the company is formed;
- determining the cost for each identified source;
- determining the weighted average cost of capital;
- formulation of conclusions on the current situation in the company;
- development of measures to optimize the structure.
- forecast indicators and their calculation.
Let's take a closer look at these steps.
Consideration of funding sources
Among the main possible sources on the basis of which the company's capital is formed can be:
- Own funds (authorized capital, additional, reserve, retained earnings).
- Borrowed funds (loans, loans from third parties, bonds, etc.).
Determining the cost
We calculate the cost of each source:
- The cost of borrowing a bond is equal to the income received by the holder of the security. The cost is not adjusted for income tax.
- Long-term loans by value may include interest on full or partial use. Price calculation is carried out according to the formula:
CK=SP(1-SN), where CC is the price of the loan (%), SP is the interest rate on the loan (%) and SN is the tax rate (%).
This formula is very common in Western conditions, but in Russia it is slightly adjusted, due to the fact that not the entire amount of interest paid reduces taxable income, but only a fixed part:
- The value of a common share is determined by the level of dividends.
- The value of a preferred share is determined by the level of dividends by dividing the amount of annual payments by net incomefrom sale. No income tax adjustment.
- The value of retained earnings is the expected return on common stock. It is determined in the same way as in the case of ordinary shares.
Calculation of weighted average cost
To calculate the cost, a special formula is used:
WACC=DkƩIR.
Here, WACC is the weighted average cost of capital.
Dk - the share of the source in the total.
IR - the price of the source of capital.
It is necessary to determine the minimum weighted average for calculating capital structure optimization.
An example of calculation is shown in the table below.
| Source | Amount | Weight, % | Dividends, % | Weighted cost, % |
| Borrowed short-term funds | 5000 | 30 | 20 | 6 |
| Long-term loans | 4500 | 12 | 10 | 1, 2 |
| Ordinary shares | 10000 | 40 | 18 | 7, 2 |
| Preferred shares | 3500 | 18 | 13 | 2, 34 |
| TOTAL | 23000 | 100 | - | 16, 74 |
Thus, the cost of capital is 16.74% in example 16.
This value shows the level of expenses the firm (in %), which it incurs each year for the ability to carry out its activities when using financial resources on a long-term basis.
This value can also be used as a discount rate for cash flows in investment calculations. It implies the value of the opportunity cost of raising capital by the firm. In our example, when using the value of 16.74% in investment calculations, we can conclude that the rate of return on investments in any assets cannot be less than 16.74%.
It can be concluded that the main purpose of determining the weighted average cost of capital is to assess the situation that has actually developed in the company, as well as to determine the price of a newly attracted monetary unit. Subsequent use is possible as a discount factor when budgeting investments.
Optimization
This stage is very important, as it allows you to find the ratio that will be optimal for this company in the current market situation.
There is a trade-off between maximizing tax savings and the additional costs associated with increasing the likelihood of financial bankruptcyfirms.
In the conditions of stable development of the company, the weighted average cost of capital is constant when the amount of attracted resources changes, but when a certain limit of attraction is reached, it starts to grow.
The use of financial leverage can be called as a mechanism for optimizing the capital structure. The effect of this leverage is expressed in the fact that funds borrowed at a fixed percentage can be used only for those projects that can provide a higher return than the interest on loans and borrowings itself. This is the so-called border of the expediency of using borrowed resources for a company, which you should not cross in order not to fall into debt dependence.
