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Capital Structure Optimization: Theoretical Problems and Empirical Solutions

ArticleinSSRN Electronic Journal · January 2017

DOI: 10.2139/ssrn.2966307

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Andrey Zahariev

D. A. Tsenov Academy of Economics - Svishtov

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Electronic copy available at: https://ssrn.com/abstract=2966307

Capital structure optimization: theoretical problems and empirical solutions 1

Capital structure optimization: theoretical

problems and empirical solutions

Prof. Andrey Zahariev, PhD

D. A. Tsenov Academy of Economics

Department of Finance and Credit

[email protected]-svishtov.bg

Summary:

The aim of this research is to introduce a methodology for the

optimisation of capital structure of companies, on the basis of

fundamental company indicators and stock exchange rates. A similar

methodology provides the answer to a series of questions and solves

significant problems faced by business practice, related to the realisation

of the main purpose of financial managers of public companies –

maximising stock wealth. The achievement of this aim is based on the

effect of financial leverage on the profit of one share and its stock

exchange capitalisation. Therefore within the range of the research, we

identify four separate group of problems in the field of applied capital

optimisation which require precise financial and investment

circumstances and appropriate solutions. The research includes five parts:

First. Technology for modification of the balance sheet positions of the

company; Second; Methodology for construction of the risk adopted

corporate interest rate curve; Third. Technology for maximization of EPS

and technology for evaluation of the company’s risk; Fourth.

Maximization of Value per Share; Fifth. Empirical findings for the blue

chip companies on the Bulgarian capital market.

Key words:

Capital structure, EPS maximization, Business Risk, P/E Ratio,

WACC, CAPM

JEL:

G32, G34

Electronic copy available at: https://ssrn.com/abstract=2966307

Capital structure optimization: theoretical problems and empirical solutions 2

Introduction

The cost of capital is the major theory of the modern financial

theory. The relation between cost financing (the right side of the balance

sheet) and the rate of return (the left side of the balance sheet) is a

milestone of all strategies for the development of the modern financial

management concept. The cost of capital is a mathematical function of the

capital structure, its components and the companies’ income tax burden.

Therefore the problem of optimizing the capital structure is still a vital

area of scientific research and empirical findings.

The aim of this paper is to introduce and test a methodology for

the optimisation of capital structure of public companies, on the basis of

fundamental company indicators and stock exchange rates. A similar

methodology provides the answer to a series of questions and solves

significant problems faced by business practice, related to the realisation

of the main purpose of financial managers in public companies –

maximising stock wealth. The achievement of this aim is based on the

effect of financial leverage on the profit per share and its market

capitalisation. The initial finding of Modigliani and Miler (1958, 1959

and 1963) started a large process of scientific debate where the practical

solutions of empirical problems of the capital structure of the public

companies are often underestimated. Therefore within the range of the

research, we identify various groups of problems in the field of applied

capital optimisation technology which require precise financial and

investment circumstances and appropriate solutions.

The research includes five parts: First. Technology for

modification of the balance sheet positions of the company; Second;

Methodology for construction of the risk adopted corporate interest rate

curve; Third. Technology for maximization of EPS and technology for

evaluation of the company’s risk; Fourth. Maximization of Value per

Share; Fifth. Empirical findings for the blue chip companies on the

Bulgarian capital market.

1. Technology for modification of the balance sheet positions of

the company

The methodology defended by the author for the optimisation of

long-term financing of Bulgarian public companies in the period 2010-

2013 adheres to the theoretical basis and empirical evidence developed in

Electronic copy available at: https://ssrn.com/abstract=2966307

Capital structure optimization: theoretical problems and empirical solutions 3

our earlier researches (See: Zahariev (2011; 2012; 2014a and 2014b)). In

a theoretical and applied aspect, emphasis is placed on the joint-stock

company Sopharma AD using financial data for the period 1 January 2010

– 31 December 2012. The issue of transposing the accounting data of the

balance of the company for the purposes of capital optimisation requires a

precise overview of the structure of liabilities. On this basis, we defend

the thesis regarding the applicability of three stages of modification of

balance positions for the public joint-stock company for the purposes of

optimizing the capital structure of Bulgarian public companies:

 Stage one. The systematization of capital balance (see Table

1);

 Stage two. The systematization of the modified balance of

owner’s equity and long-term liabilities (see Table 2);

 Stage three. The construction of a modified non-leveraged

capital balance (see Table 3).

The present-day analysis of the evolution of the global financial

and economic post-crisis recovery justifies the importance of the specific

dynamics of the company's capital structure and volume in terms of its

business cycles and market segmentation.

The aim is to approbate a technology for optimization of the

capital structure of Bulgarian companies using empirical data as of 2011.

First we shall analyze the financial data published by Balgarska Roza –

Sevastopolis PLC as of 31 Dec. 2010. The area of the research are several

bench mark public companies in terms of their business exposure,

maximum earnings per share, the beta coefficient of their stocks and the

optimality of their capital structure. The model follows the concepts

included in theories of Modigliani and Miler (1958) and is applied to

empirical data with specific technological recommendations by the

author.

The financial profile of the public companies in Bulgaria is

determined by their equity structure, stock price dynamics and economic

sectors they operate in. The subject of this study is Balgarska Roza –

Sevastopolis PLC (4BJ/SEVTO) – a company that produces and trades in

essential oils, cosmetics, chemical substances and drugs

1

. The company is

a benchmark for its sector, which represents Bulgaria's comparative

advantages on an international scale. The stock of the company is traded

1

http://www.infostock.bg/infostock/control/profile/SEVTO

Capital structure optimization: theoretical problems and empirical solutions 4

on the official stock market – in Segment "B". The company’s equity

structure is as follows:

2

Shareholder:

Equity share:

Sopharma AD

49.99%

Other legal entities

23.70%

Telso AD

9.99%

Individuals

9.71%

DOVERIE - United Holding PLC

6.61%

In the period 13 Dec. 2010 – 12 Dec. 2011 the company's stock

index was negative reaching -7.41% compared to the value of the SOFIX

index of -15.82%. The financial synthesis of the accounting balance sheet

(Table 1) allows us to modify the accounting balance sheet by extracting

the long-term financing elements – equity and debt. The capital resources

are used mainly to finance long-term assets and current assets with long-

term debt and equity.

The initial stage of the optimization of the capital structure of

Bulgarian public companies consists of modifying the accounting

balance sheet by transferring the long-term (debt and equity) financing

(Table 1) and retaining the shareholders' equity and retained earnings into

2

Ibid.

Capital structure optimization: theoretical problems and empirical solutions 5

the liabilities part (Table 2) in order to avoid all entries from revaluations

and other accounting revalorization techniques.

Table 1

I. Modified balance sheet of Balgarska Roza – Sevastopolis PLC

(4BJ / SEVTO) as of 31 Dec. 2010 (1)

ASSETS

LIABILITIES

#

Item

Amount in

BGN

#

Item

Amount in

BGN

1.

Non-current assets

19 374 000

1.

Shareholders' equity

12 066 000

2.

Current assets

financed with long-

term liabilities

3 544 000

2.

Reserves

3 273 000

3.

Retained earnings

from previous periods

4 764 000

4.

Long-term liabilities

2 815 000

TOTAL ASSETS

financed with long-

term liabilities and

equity

22 918 000

TOTAL

LIABILITIES:

22 918 000

The essential second stage of the optimization is the synthesis of

the company's income statement (Table 3) for the last three years. Our

aim is to use actual empirical data and estimate the revenues and expenses

in terms of three scenarios – pessimistic (25%), realistic (50%) and

optimistic (25%). For the purposes of our optimization model we assume

that the company distributes all earnings as dividends, i.e. EPS=DPS. The

above data show that after the second stage of the modification of the

synthesis of the company's balance sheet the book value exceeds 1.39

times the face value per share.

Table 2

II. Modified balance sheet of Balgarska Roza – Sevastopolis PLC

(4BJ / SEVTO) as of 31 Dec. 2010 (2)

ASSETS

LIABILITIES

#

Item

Amount in

BGN

#

Item

Amount in

BGN

1.

Non-current assets

19 374 000

1.

Shareholders' equity

12 066 000

2.

Current assets

financed with long-

term liabilities

-2 544 000

2.

Reserves

0

3.

Retained earnings

from previous

periods

4 764 000

4.

Long-term liabilities

0

TOTAL ASSETS

16 830 000

TOTAL

LIABILITIES:

16 830 000

Capital structure optimization: theoretical problems and empirical solutions 6

Table 3

III. INCOME STATEMENT

of Balgarska Roza – Sevastopolis PLC

Item:

Amount in

BGN thousand

Item:

Amount in

BGN thousand

Expenditures

Depreciation (D)

2010

13210.00

2010

740.00

2009

11971.00

2009

736.00

2008

12518.00

2008

606.00

Average annual

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