Features of the capital structure of Russian and Uzbek companies

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CONTENT

INTRODUCTION

CHAPTER 1

1.1 DEFINING CAPITAL STRUCTURE

1.2 THE OBJECTIVES OF THE FORMATION OF A CERTAIN CAPITAL STRUCTURE

1.3 CAPITAL STRUCTURE THEORY

1.3.1 THE TRADITIONAL THEORY OF CAPITAL STRUCTURE

1.3.2 MODIGLIANI AND MILLER'S THEORY

1.3.3 TRADE-OFF THEORY

1.3.4 PECKING ORDER THEORY

1.3.5 SIGNALING THEORY

1.3.6 MARKET TIMING THEORY

1.3.7 AGENCY THEORY

CHAPTER 2. EMPERICAL STUDIES

2.1 CAPITAL STRUCTURES IN DEVELOPING COUNTRIES

2.2 CAPITAL STRUCTURES IN DEVELOPED COUNTRIES

2.3 CAPITAL STRUCTURES IN UZBEKISTAN AND RUSSIA

2.4 LITERATURE REVIEW

CHAPTER 3. DATA AND METHODOLOGY

3.1 DATA AND SAMPLE

3.2 HYPOTHESIS

3.3 DEPENDENT, INDEPENDENT VARIABLES

CONCLUSION AND RECOMMENDATIONS

LIST OF REFERENCES

INTRODUCTION

Since the emergence of the first entrepreneurs, as well as the first firms and companies, the question of what means this association will exist and function, was quite acute, because without money and liquidity funds any association aimed at extracting profit from its own operations guaranteed fall, bankruptcy and termination of existence. Accordingly, the question of the capital structure, or the structure of the formation of funds for the life of the enterprise, is characteristic of any company or company for a huge number of decades and even centuries.

The capital structure is a “characteristic of the balance sheet of a corporation, the relative ratio of short-term liabilities, long-term liabilities and equity”. In other words, the structure of capital means the method of financing the sources of a company's assets using a combination of equity, debt and other financial instruments.

Financing assets through various financial instruments is quite a costly operation, as the company incurs costs when it issues shares to create equity capital, and also when it attracts funds through debt issuance and other financial instruments. Moreover, the company bears tangible costs, trying to maximize the returns it brings to both lenders and shareholders. Thus, the capital structure is one of the most important and key concepts in the functioning of a firm, since any association is aimed at maximizing profits, i.e. minimizing costs and expenses, and maximizing the value of your business. The task of any manager is to determine the optimal capital structure, which would be the least expensive and maximize the value of the company, which would lead to the maximization of shareholders' incomes, in which the firm's manager must act.

Thus, analyzing the companies' capital structure is considered one of the most vital operation for companies as it affects the companies' value either positively or negatively. That's why, financial managers seek optimal capital structure which leads to increase a company's returns and profitability. Since the proposition of the irrelevance of the capital structure by Modigliani and Miller (1958), numerous capital structure explanations and theories have been suggested. However, Trade-off theory, Market Timing theory and Packing order theories are considered as major ones in capital structure formation and explanation. [1]

Although a great deal of theories have been put forward to identify the impact of the financial leverage decision on market value of a firm, it still does not mean that formation of optimal capital structure has been fully identified. Debt to equity ratio really matters in the valuation of market value of a company. To maximize the stockholders wealth, managers can increase the leverage proportion in companies capital mix as debt is tax-deductible and decreases the effective cost of debt. Conversely, the more the debt is used, the riskier it is to operate for the firm. Because of the fact that it may lead to higher capital cost. [1] Therefore, it is vital to approach each company's financial leverage decision individually, taking into account the significant elements of structure of the capital.

The choice of the optimal capital structure, that is, the ratio between borrowed and own funds of the company, which minimizes the weighted average cost of capital and maximizes the company's capitalization, is one of the most important tasks solved by the financial manager and the management of the organization. The search for the optimal capital structure has stirred the minds and attracted the attention of economists and financiers for many decades.

The acceleration of market changes, which places entirely new, more stringent requirements on all subjects of market relations, both national (including Russian) and global markets, is the most important characteristic of modern economic conditions. Market changes are avalanche-like, and thereby multiply the uncertainty and the risks it causes.

Under these conditions, the efficiency of an enterprise's activity is largely determined by the ability of its owners and management to correctly assess the content of market changes, and on the basis of this assessment, work out an effective strategy for its development. Thus, the management of enterprises faces a number of tasks that require effective solutions.

One of these tasks is to determine such an optimal capital structure that would meet the requirements of both the economic situation as a whole and the management of the company, taking into account its features at a certain stage of development.

The demands of the external economic situation are characterized by dynamism and uncertainty of external influences, which is due to the influence of globalization, as well as the expansion of the range of possible, and at the same time, associated with increased risk options for investing available resources. The requirements of the firm's management are due to the fact that the competitive environment presupposes the effective functioning of such economic entities that are able not only to attract resources, but also to determine their ratio that would be optimal under given conditions.

Such an optimal capital structure involves ensuring the financial stability of the company, the achievement of standards for its current liquidity and solvency, as well as the required return on invested capital. All of the above determines the relevance of the topic of this

Although different researchers and scientists have proposed numerous theories, it can not be said that just one single theory can fully depict or explain the financial behaviors of the firms.

The relevance of this work is that the task of forming the capital structure at the same time represents a key and one of the most difficult tasks solved in the field of corporate finance. As a result, the organization's goal is to simultaneously minimize the actual cost of borrowed funds and minimize the risk of bankruptcy. So this work is devoted to identify how the companies in Russia and Uzbekistan deal with this problem.

The aim of the work is to study the theoretical foundations of determining the capital structure of Russian and Uzbek companies, analysis of the biggest companies in both Russia and Uzbekistan, which have an influential impact on the economy of the countries.

The object of the study is biggest listed companies in Russia and Uzbekistan which are traded on Moscow stock exchange and “Toshkent” stock exchamge.

The subject of the study will be the economic relations arising in the process of formation and management of the capital structure the companies in both countries.

The objectives of the dissertation research correspond to the following tasks:

1. To study the basic approaches of the assessment of capital structure.

2. Consider the proposed methods and identify their positive and negative sides.

3. Analyze the main financial indicators and financial architecture of the selected companies of the study.

4. Based on a comprehensive analysis of the companies, determine the current capital structure and find out country differences of Uzbek and Russian companies.

The research methods in this paper will be quantitative and qualitative methods for determining the capital structure of Russian and Uzbek companies and analyses the country differences.

The empirical base for the study of this work is the reference materials, as well as scientific journals and articles.

The base of the research is publicly available information on the financial history of the companies analyzed, which is annually published by the company on the official website, as well as all historical facts of the company's operation in the national and foreign markets.

The practical significance of the study consists in comparing country differences of companies in Russia and Uzbekistan to analyze their reliance on leverage to form their capital structure.

The structure of the study consists of an introduction, three chapters and a conclusion. The first chapter discusses the capital structure from the theatrical point of view. In the first paragraph of the chapter, capital structure is defined briefly. In the second paragraph, the common capital structure theories are considered, which make it possible to determine the rational value of the capital structure and their theoretical justification.

The second chapter is devoted to the explanation of the capital structure in developed and developing countries, which suggest the main factors and variables influencing significantly on capital structure of companies.

In the third chapter, country differences of capital structure in Russia and Uzbekistan explained with the results achieved by analyzing the data collected.

In the conclusion of the work contains a summary of earlier conclusions for each chapter, scientific and practical results of the study.

CHAPTER 1

1.1 DEFINING CAPITAL STRUCTURE

At the present stage of economic development, each company conducts its activities in a serious competitive environment. The effectiveness of the company in these conditions largely depends on the peculiarities of the formation of the capital structure.

The capital structure is a combination of financial assets of an enterprise from various sources of long-term financing, or more precisely, the ratio of short-term liabilities, long-term liabilities and own capital of an organization.

The capital structure mainly identifies the conditions for the formation of such financial results of a company as return on assets, return on equity, level of financial stability and solvency, level of financial risks and ultimately the effectiveness of financial management as a whole. Therefore, finding the right balance between the own and borrowed capital to maintain the optimum financial mix is the object of research of many economists.

Capital structure formation is inextricably linked with the characteristics of each of its constituent parts.

The formation of the financial structure of the company begins from the moment of its creation and is the most important aspect of its activity.

Liability articles are grouped into three sections:

1. Shareholders Equity (the section reflects the total "debt" of the company to its founders.

2. Long-term liabilities (the section provides long-term debt to third parties, which must be repaid within the terms established in the contract).

3. Short-term liabilities (this section also reflects debt to third parties, but it is short-term in nature and some types of debt arise in the course of financial and economic activity).

Equity is determined by the value of property owned by the company and represents the difference between total assets and its liabilities. It is divided into constant and variable parts. The permanent part includes the share capital. It reflects the amount of funds allocated by the owners of the company for economic activities. The minimum share capital is set by Russian law and depends on the form of ownership of the company. The authorized capital is reflected in the amount determined by the constituent documents, in this connection for the joint-stock company the value of the authorized capital is equal to the sum of the nominal values ??of the shares regardless of the price actually paid for them. The absolute value of the authorized capital has a certain significance only at the time of the establishment of the company, and subsequently it is allowed to increase (decrease) by the decision of the owners according to the results of the meeting for the year with the obligatory change of constituent documents.

The variable part of the equity depends on the financial results of the company. It includes: additional capital, reserve capital, retained earnings and special funds.

The reserve capital reflects the company's reserves formed at the expense of the net profit, which cannot be used to pay dividends. Retained earnings - the company's profits, net of taxes, dividends and other similar mandatory payments.

Borrowed capital consists of cash and other property values raised to finance the company on a returnable basis. All forms of borrowed capital that are used by an enterprise are its financial obligations that are repayable within the stipulated period. The composition of borrowed capital includes short-term and long-term debt obligations.

Short-term borrowings serve the current cash needs of the company associated with the movement of working capital. Long-term borrowings serve the needs of the company to form fixed capital and financial assets.

An important characteristic of any funding source is payment, almost all sources are paid, but the cost of each source is different, the structure of possible sources of funding for the company. The most important component of the company's capital structure are long-term sources of financing, since with an increase in their share entails an increase in financial risk. Attracting this borrowed capital within reasonable limits is beneficial for the company, since the cost of its maintenance reduces taxable income.

The own and borrowed capital has its own advantages and disadvantages.

Equity usually brings the following advantages:

? simplicity of attraction, as the owners and managers of the enterprise make decisions related to the increase in equity by themselves, without the interference of the consent of other economic entities;

? a higher capacity to generate profits in all fields of activity, as it is interest free;

? ensuring that the company is solvent and financially sustainable, accordingly avoiding the possibility bankruptcy, efficient use, minimal financial risks.

Downsides of internal financing:

? The limited amount of funds raised does not allow for a significant expansion in the size of the company's operating and investment activities, as a result of which, in the conditions of an enterprise's profitable operation, its own capital is much more expensive compared to borrowed funds.

? high cost in comparison with alternative borrowed sources of capital;

? unused opportunity to increase the return on equity ratio due to the effect of financial leverage, since without attracting borrowed capital it is impossible to ensure that the ratio of the financial profitability of an enterprise exceeds the economic one.

Thus, a company which relies only on its own capital maintains the highest financial stability (its autonomy coefficient is equal to one), but the pace of its development will be limited. As it lacks to attract further required assets to use the financial growth opportunities return on invested capital (i.e., does not get the effect of financial leverage).

Borrowed capital is characterized by the following positive features:

? Different conditions of attraction, a significant amount, an increase in the company's turnover, an increase in financial profitability;

? The amount of borrowed capital that can be attracted far exceeds the potential amount of self-financing, especially with a high credit rating of the company, availability of collateral or guarantees of external guarantors.

? Ensuring the growth of the financial potential of the enterprise, if necessary, a significant expansion of its assets and growth in the volume of economic activity;

? The ability to raise funds under different conditions is important if you need to simultaneously finance your current business and invest in a new business.

? Lower cost in comparison with own capital due to the effect of the “tax shield” (removal of the cost of its maintenance from the taxable base when paying income tax);

? The ability to form an increase in financial profitability (return on equity) due to the effect of financial leverage.

Disadvantages of using borrowed capital:

? The use of this capital creates the most dangerous financial risks in the economic activity of the enterprise - the risk of deterioration of financial stability and loss of solvency. The level of these risks increases in proportion to the growth of the share of borrowed capital in the total amount of capital;

? Assets formed at the expense of borrowed capital, give a lower (ceteris paribus) rate of return, which decreases by the amount of credit interest;

? High dependence of the cost of borrowed capital from fluctuations in the financial market conditions. In some cases, with a decrease in the average interest rate on the market for the use of loans received earlier (especially on a long-term basis), the enterprise becomes unprofitable due to the availability of cheaper alternative credit resources;

? The complexity of the procedure for attracting (especially in large amounts), since the provision of credit resources depends on the decision of other economic entities (creditors), in some cases requires appropriate third-party guarantees or collateral (while guarantees of insurance companies, banks, etc., are provided on a fee basis).

The main advantages of attracting borrowed capital include:

The disadvantages of the use of borrowed capital include significant financial risks, a decrease in the rate of profit, and the complexity of attracting. Significant financial risks are risks of reduced financial stability and loss of solvency. Their degree increases in proportion to the growth of the share of borrowed capital. Also, the use of assets generated by borrowing leads to a lower rate of return. Thus, the main task of financial management in the formation of the company's capital structure is to achieve the optimal balance between risk and return, to take into account all the disadvantages and advantages, that is, to come to an optimal capital structure. This ratio maximizes the fair market value of the business.

Thus, an enterprise using borrowed capital has a higher financial potential for its development (due to the formation of an additional amount of assets), and opportunities for increasing the financial profitability of activities (due to using the effect of financial leverage), but to a greater degree generates financial risk and the threat of bankruptcy which increase with the increase in the share of borrowed capital in the total amount of capital used.

1.2 THE OBJECTIVES OF THE FORMATION OF A CERTAIN CAPITAL STRUCTURE

capital financial company analysis

The policy of capital structure formation is an integral part of the enterprise profit management policy, which is to ensure such a combination of using own and borrowed capital that optimizes the ratio of financial profitability and level of financial risks in accordance with selected profit management criteria.

There are a number of factors, the consideration of which allows to purposefully form the capital structure, to ensure the conditions for the most efficient use of it in each particular enterprise:

1. Industry features of the operating activities of the enterprise. Enterprises with a high level of capital intensity of production due to the high proportion of non-current assets have a lower credit rating and are forced to focus on the use of equity. In addition, the nature of industry characteristics determines the different duration of the operating cycle. The smaller the period of the operating cycle, the more can be used by the enterprise loan capital.

2. Stage of the life cycle of the enterprise. Growing enterprises in the early stages of the life cycle should be able to use a large share of borrowed capital, although for such enterprises the cost of this capital may be higher than the average market. Enterprises in the maturity stage should make greater use of their own capital.

3. The conjuncture of the commodity market. The more stable the situation, the more stable the demand for the company's products, the safer it becomes to use borrowed capital.

4. Financial market conditions.

5. The level of profitability of operating activities. With a high value of this indicator, the company's credit rating is high and it expands the potential for the use of borrowed capital.

6. The ratio of operating leverage. The growth of profits of the enterprise is provided by the combined effect of the effect of operating and financial leverage. Therefore, enterprises with growing sales volumes and having a low operating leverage ratio can increase the leverage ratio to a greater extent, i.e. use a large proportion of borrowed funds in the total amount of capital.

7. The ratio of creditors to the company.

8. The level of income taxation.

9. The financial mentality of the owners and managers of the enterprise. the rejection of high levels of risk forms a conservative approach of owners and managers to finance the development of an enterprise, in which the basis is equity. In addition, conversely, the desire to get a high return on equity, despite the high level of risk, forms an aggressive approach to financing the development of an enterprise, in which borrowed capital is used to the maximum extent possible.

10. The level of concentration of equity. In order to maintain financial control over the management of the enterprise-controlling stake, the owners of the enterprise do not want to attract additional capital from external sources, despite the favorable conditions.

Taking into account these factors, the management of the structure of capital in an enterprise is reduced to two main areas:

The establishment of optimal for the enterprise proportions of the use of own and borrowed capital;

Ensuring attraction of the necessary types and volumes of capital to the enterprise to achieve the estimated indicators of its structure.

1.3 CAPITAL STRUCTURE THEORY

1.3.1 THE TRADITIONAL THEORY OF CAPITAL STRUCTURE

Prior to the Modigliani and Miller's first proposition in 1958 [70], the irrelevance of the capital structure, it was believed by many financial theorists that the capital structure optimization can be reached when the weighted average cost of capital (WACC) is as low as possible, while the firm value at its maximum. This theory considers that financing mix is required to form the company's assets and opt the adequate capital structure balance between internal and external financing possibilities.



Figure 1: Theories of capital structure

Source: Seadin Xhaferi and Besa Xhaferi (March 2015) [2]

Traditional (empirical) theories (until 1958) told the entrepreneur that the weighted average cost of capital (WACC) and the company's associated capitalization depend on the capital structure, on the level of leverage. The cost of borrowed capital is always lower than the cost of equity due to the fact that the former is less risky (in case of bankruptcy, the claims of creditors are satisfied before the claims of shareholders). As a result, an increase in the share of cheaper borrowed capital in the overall capital structure to the extent that does not cause a violation of the company's financial stability and an increase in the risk of bankruptcy leads to a decrease in the weighted average cost of capital. At the same time, the profitability required by investors (the cost of equity) is growing, but its growth does not lead to compensation for the benefits from the use of cheaper borrowed capital.

Therefore, in the traditional approach, an increase in the level of leverage is welcomed (financial leverage, financial leverage - the ratio of the value of borrowed funds of company D to the value of its own funds S: L = D / S) and the associated increase in capitalization of the company. Traditional (empirical) ideas existed until the appearance of the first quantitative theory in 1958.

1.3.2 MODIGLIANI AND MILLER'S THEORY

Irrelevance theory of capital structure put forward by Modigliani and Miller in1958 was the starting point of modern capital structure theories. [70]

“The Modigliani-Miller model, excluding taxation, proposed in 1958, was based on the following assumptions:

1. Investors behave rationally and instantly see the possibility of making a profit that is not adequate to investment risk. Therefore, the possibility of a stable arbitrage situation, that is, obtaining a risk-free profit on the difference in prices for the same asset, cannot be maintained for any length of time - reasonable investors will quickly take advantage of it for their own purposes and level the market conditions. This means that in the developed financial capital market the same risk must be rewarded with the same rate of expected return.

2. Investment and financial opportunities in the markets should be equally accessible to any category of investors - whether institutional or individual, large or small, intensively growing or stable, sophisticated or relatively inexperienced.

3. Transaction costs associated with raising funds are very small. In practice, the magnitude of transaction costs is inversely proportional to the amount of attracted financial resources; therefore, this assumption corresponds more to reality, the greater the amount of funding. In other words, when attracting insignificant amounts, transaction costs can be large, while when attracting large loans and loans, as well as when placing shares for a significant amount, transaction costs can be neglected.

4. Investors receive money and lend money at a risk-free rate. In all likelihood, this assumption is due to the fact that the lender seeks to protect itself with the help of certain guarantees, asset pledge, the right to turn claims on third parties, provisions of contracts restricting the borrower's freedom to act to the detriment of the lender. The risk of the lender is really small, and his position can be considered risk-free in relation to the position of the borrower and, accordingly, should be rewarded only with a risk-free rate of return.

5. Companies have only two types of assets: risk-free debt and risk own.

6. There is no possibility of bankruptcy, that is, regardless of the level to which the company's leasing companies bring their financial leverage, bankruptcy does not threaten them. In other words, the costs of bankruptcy are absent.

7. There are no corporate taxes and taxes on personal income of investors. If personal taxes can really be neglected, since the company's property is separated from shareholders' property, then corporate income taxes should be taken into account when developing more realistic theories (which MM did in the second work on the capital structure).

8. Companies are in the same class of risky companies.

9. All financial flows are perpetual.

10. Companies have the same information.

11. Company management maximizes the company's equity. [4]

Most of these assumptions, of course, are unreal. However, some assumptions can be weakened without changing the conclusions of the model. However, the assumptions about the absence of taxes (or the presence of only corporate taxes) and the absence of bankruptcy costs are critical - changing these prerequisites changes the conclusions of the model. [5]

According to above mentioned assumptions, it was proved that financial leverage decision does not make any change in cost of capital, which makes financing mix irrelevant for the stockholders' wealth. From these factors, it can be understood that the value of unlevered and levered firm is the same. Hence, managers ought not to pay much attention to the proportion of the debt and equity.[6]

Although proposition of capital structure irrelevance by Modigliani and Miller is not acceptable in real-world markets, their proposition led to many more in-depth researches into the capital structure puzzle. To make their first proposition, in 1963 Modigliani and Miller incorporated the impact of tax on cost of capital. Since interest payments are tax-deductible, it reduces the payment of the net tax, resulting an increased benefit financial mix by decreasing the cost of the capital of a firm.

In 1963, Modigliani and Miller released the next paper on the capital structure, in which they put forward their original model incorporating corporate taxes, thereby making the previously accepted assumption more accurate - zero taxation. [71]

Including the corporate taxes, it was advocated that the price of a company's stock is directly related to the use of debt financing by this company: the higher the share of borrowed capital, the higher the price of shares. According to Modigliani-Miller's revised theory, firms should be 100% financed with borrowed capital, as this would provide them with the highest stock prices. Such a conclusion is due to the structure of corporate taxation in the United States -- shareholders 'income must be paid from the profit remaining after taxes, and payments to creditors are made from pre-tax profits. Such asymmetrical taxation leads to the fact that with an increase in the share of borrowed capital, the share of the firm's gross income remaining at the disposal of investors also increases.

However, usually the share of loans in the capital of the company is very far from 100%. Later, various researchers, trying to modify the Modigliani-Miller theory, in order to explain the actual state of affairs, softened many of the initial premises of this theory. It turned out that some of these prerequisites do not have a significant impact on the results obtained, but when such a factor is introduced into the model as the cost of financial difficulties of the company due to unfavorable capital structure, the picture changes dramatically. Thus, the savings due to the reduction of tax payments provides an increase in the value of the company as the share of loans in its capital increases, but starting from a certain point (when the optimal capital structure is achieved) with an increase in the share of borrowed capital, the cost

Firms are starting to decline, as tax savings are more than offset by rising costs due to the need to maintain a more risky structure of sources of funds. Modified according to the cost factor of financial difficulties, the Modigliani-Miller theory states:

1) The presence of a share of borrowed capital is beneficial to the company;

2) Too high a share of borrowed capital brings harm to the company;

3) For each company has its own optimal share of borrowed capital.

Thus, the modified Modigliani-Miller theory, called the theory of compromise between savings from reduced tax payments and financial costs (tax savings-fmancial costs tradeoff theory), allows a better understanding of the factors that determine the optimal capital structure.

Although this theory has undoubted attractiveness, the empirical evidence in favor of its correctness is very weak. Obviously, when making financial decisions, other factors also should be taken into account.

1.3.3 TRADE-OFF THEORY

The optimal capital structure according to the compromise model is determined by the ratio of the benefits from the tax shield (the possibility of including the borrowed capital in the cost price) and losses from possible bankruptcy.

Introduction to considering the costs of organizing additional attraction of borrowed capital and the costs of possible bankruptcy with a large financial leverage changes the behavior of the cost of capital curves with an increase in debt financing.

The decline in the company's financial stability and the increase in bankruptcy risk, which are associated with the use of various forms of borrowed funds in the formation of the company's financial capital structure, increase with debt.

The theory of Modigliani - Miller did not take into account the dangers of bankruptcy and the costs associated with it. Thus, from its version, taking into account the income tax, it followed that debt-financing carries with it only one of the advantages associated with tax privileges (tax shield).

As the value of the company increases with leverage and there is no compensating increase in the cost of loans, the growth of capitalization dictates the 100% use of debt financing. This apparent contradiction with the real economy gave rise to many theories that tried to strike a balance between the advantages and disadvantages of using debt financing by companies.

The advantages are a decrease in the weighted average cost of capital and a corresponding increase in the company's capitalization, and the disadvantages are a decrease in the company's financial stability with increasing borrowing and an increase in financial distress costs and bankruptcy risk.

Trade off theory suggests that companies rely on one optimal debt ratio, focusing on finding the balance between the tax shield and financial distress cost.[7] The theory was proposed by Kraus and Litzenberg (1973). According to the trade-off theory, companies try to strike the balance, thereby adjusting towards the optimal debt ratio between the bankruptcy costs and tax-savings.” [8]

The tradeoff theory develops the theory of Modigliani and Miller, taking into account taxes. Having weakened the statement about the absence of transaction costs, the authors of this theory come to the conclusion that 100% debt (as the theory of Modigliani and Miller with tax included) because of the costs of financial difficulties cannot be the optimal capital structure. The optimal capital structure can be achieved when the marginal effect of the increase in tax savings is equal to the marginal cost of financial distress. [9]

Main plus point of the theory is that external financing creates an opportunity to rise the amount of returns to the stakeholders of equity by providing a tax shield.

According to the premises of the trade-off theory, the traditional determinants of capital structure should have the following influence on the optimal level of debt burden:

? The larger the company, the higher the optimal level of debt burden due to lower costs of financial instability and higher tax benefits;

? The higher the growth potential of the company, the lower the optimal level of debt burden due to higher financial instability costs;

? The higher the share of the company's long-term tangible assets in total assets, the higher the optimal level of debt load due to lower financial instability costs;

? The higher the profitability of the company's aggregate capital, the higher the optimal level of debt burden due to lower costs of financial instability and higher tax benefits.

However, the findings of empirical studies of the determinants of capital structure did not completely confirm the companies' adherence to the static compromise theory. Thus, the observed inverse relationship between the debt level chosen by the company and the return on total capital contradicts the conclusions outlined above. [10]

There are two variants of the trade-off theory: static and dynamic. It is based on the fact that, with a low level of leverage, the advantages of debt financing are manifested: WACC falls with leverage, and the company's capitalization grows. Starting from a certain level of leverage, the company faces and grows financial difficulties, the risk of bankruptcy increases, the growth of WACC and the fall in the company's value begin. The level of leverage at which the cost of tax benefits is approximately equal to the costs of bankruptcy determines the optimal (target) capital structure. In this case, the composition of the costs of bankruptcy are allocated direct and indirect costs. Direct costs are related to the bankruptcy of the company itself, they include a decrease in the liquidation value of assets due to litigation between creditors, legal costs, lawyers and an external manager, etc. Indirect costs appear before the company is declared bankrupt, at the stage of financial difficulties; These include losses from a decrease in effective financial decisions, from a change in the behavior of lenders, buyers, suppliers and other contractors. Thus, with the growing threat of bankruptcy of a company, its creditors can either reduce the amount of borrowed capital provided, or demand a higher level of income in order to compensate for the increased risk of non-repayment of borrowed funds.

Firms obey this model, if:

The firm follows this model, and if so, it selects its capital structure, motivating these decisions with cautious estimates of the benefits of debt financing. That is, it determines its financial leverage, based on the benefits of debt financing, primarily caused by tax savings. And based on the costs of financial instability within one period.

Firms produce for this period a certain definite ratio that is considered to be optimal level of debt in the capital structure, which allows it to have a minimum cost of total capital. the company must decide moving to the next level of financial leverage, since it determined that then there would be minimal capital costs. The companies must do it essentially in the same period.

Source: D.K.Y Abeywardhana (2017) [11]

As can be seen from the figure above, as the amount of debt in the capital increases, the WACC of the firm declines till the debt/equity ratio reaches its optimal gearing level. However, its financial distress cost increases simultaneously.

The main drawback of the theory is that it excludes the asymmetry of the information and doesn't incorporate different conflict relating information between the managers and external investors as Pecking Order Theory does. [12]

The trade off theory can be indicated as following:

V(firm)= V + PV(interest tac shield) - PV (costs of financial distress) [12]

Thus, the cost of a leverage company corresponds to the value of a company financed entirely from its own funds, plus the cost of benefits from the tax shield and minus the present value of the costs of bankruptcy. Other things being equal, the growth of liabilities leads, on the one hand, to an increase in tax shields and an increase in the value of the company, and on the other hand, an increase in the probability of bankruptcy, which in turn increases the expected costs of bankruptcy and leads to a decrease in the company's value.

The trade-off theory asserts the existence of an optimal level of debt-equity ratio, i.e. optimal capital structure of the company, which leads to a compromise of tax benefits and the cost of bankruptcy of debt obligations. So far, this theory remains one of the most important theories of capital structure, explaining the optimal level and combination of various financial instruments that make up the capital of various companies.

The main determinants reflecting the idea of ??this theory of capital structure are tax, company size, non-debt tax shield, tangibility, growth opportunities (investment opportunities), risk level (volatility of company income) and profitability.

1.3.4 PECKING ORDER THEORY

Myers and Majluf explained how the asymmetry of information influences to form the capital structure of companies by proposing the pecking order theory. [14] Their model is considered as a fundamental investment model, and is focused on an analysis of the preferences of managers in choice of financing source, which is dependent on the information insiders have. The information asymmetry between insiders and external investors is the key supposition of this theory. It suggests that asymmetry of the information causes an increase in the cost of financing, thus when extra financial recourse is needed, a company prefers retained earnings over debt, and would rather debt over equity. [13]

According to Brigham and Ehrhardt's research in 2008 [15], issuing new equity by the company to fund the new investment project is considered as a negative signal since investors conclude that the firm is overvalued, thereby leading to a decrease in price shares of company and the value of it as well. Companies operating close to its debt capacity point usually issue equity, although the attraction of debt can benefit to the company. Relying on the above-mentioned views, it is summed up that the debt to equity ratio of the both traditional trade-off and pecking order theories are similar to each other, which may lead to a little bit confusion to differentiate them. However, the theory used by the company can be identified by checking whether the firm has already used all its internal financing capacity (retained earnings) or not, if so it is assumed that the company is following the pecking order theory. ”

Moyo considers that managers that tend to use the pecking order theory usually follow the external financing hierarchy mentioned below: [16]

? Retained earnings;

? Straight debt financing;

? Lease financing;

? Convertible financing;

? Ordinary equity;

Myers suggests that the company should finance its new investments and financial slack by the way of issuing equity as long as the asymmetry of information is less. [17]

The hierarchy theory assumes that a single firm does not have any specific planned debt ratio. The company will always strive to attract first the source of the highest hierarchy, which will have the lowest cost of attraction and the lowest risk. Thus, at first, the firm will exhaust domestic sources of financing, then resort to loans, and only then issue hybrid securities (convertible bonds, preferred shares) and only as a last resort - ordinary shares.

Based on this, we can conclude that the debt ratio of any company reflects its needs for external financing. In general, the theory of hierarchy is an attempt to describe the real behavior of companies, rather than offering an optimal capital structure that would maximize the firm's total market value. It can be assumed that managers who follow the provisions of this theory, simply follow the path of least resistance and do not seek to maximize the value of the company. However, this minimizes the risks and costs of attracting sources of financing, which can serve as a purely economic rationale for this theory. In addition, by resorting first to internal sources of financing, firms create a so-called financial barrier in the form of cash, easily marketable securities and unused credit intensity, which reduces the risk of a forced issuance of shares in the future. It should also be noted that the issue of shares reduces their rate, which negatively affects the welfare of shareholders, which is why firms resort to issuing them as the last thing.

The behavior of managers of large companies in countries with developed market economies and in Russia as a whole can be described using hierarchy theory, but there is no strict confirmation of its correctness in economic theory.

This theory does not take into account a number of important factors that affect the capital structure and determine the type of financing for specific investment projects. So, for example, M. Lipson and S. Mortal found that the higher liquidity of the company's shares entails lower leverage levels [18]. In addition, companies with high-liquid stocks, as a rule, resort to the issue of equity capital, and not equity, which is not consistent with the theory of hierarchy.

Although many researchers have supported the pecking order theory with their empirical finding, it lacks explaining some aspects of capital structure formation. For example, it excludes the impacts of financial distress costs and taxes. However, the trade-off theory explains how the leveraged companies takes advantage of tax-shields or how the companies suffer from financial distress.

The theory of the sequence of actions, on the contrary, does not attach much importance to the advantages of the debt tax shield and the costs of financial difficulties. According to this theory, firms have a hierarchy of preferences in relation to sources of financing, which is explained by the presence of information asymmetry between managers and investors. Preferred are internal sources that are shared by company management decisions. With other things being equal, the company prefers financing from retained earnings to all other sources of financing. External sources requiring consent or determined by the decision of external persons should be addressed only when there are not enough internal sources to finance projects with positive net present value (NPV), the company prefers borrowed funds to issue new shares.

At the same time, models based on the inclusion of elements of the theory of agency relations in the theory of capital structure are gaining in popularity (the influence of manager-shareholder and shareholder-creditor conflicts on the choice of capital structure becomes the subject of research). [19]

An alternative direction of development of the theory of capital structure was the theory of the sequence of actions (pecking order theory). This theory is based on empirically observable policies for financing enterprises. In real life, most profitable companies make a minimum of loans, i.e., with high profitability, there is under-utilization of borrowed capital. At the same time, with a small profit, there is an increase in borrowing, i.e., the share of borrowed capital is higher than optimal. However, according to the theory of Modigliani and Miller, everything should be exactly the opposite: high profits mean greater opportunities for debt servicing and a greater need for tax protection, and, consequently, a higher debt burden ratio. The practice of debt management corporations was first investigated by G. Donaldson and received its further development in the works of S. Myers, who noted the following facts regarding the financing policies of companies [20]:

1) Companies prefer financing from internal reserves;

2) The target value of the dividend payout ratio is set on the basis of expected future investment opportunities and expected cash flows. Domestic sources are primarily used to finance the necessary investments, projected for a long term, and the portion of these reserves that remains after the investments are made will be used to pay dividends;

3) In the short term, dividends are stable, and investment opportunities and cash flows change annually. Therefore, for each year, internal reserves may be sufficient or insufficient for the use of investment opportunities;

4) If in a particular year the company's cash flow turns out to be more than necessary to make investments, then free cash will be invested in the securities market or used to pay off debt. If the cash flow is insufficient for the implementation of investment projects, then the firm will raise the necessary funds in the following order:

* sell a portfolio of liquid securities;

* attract ordinary loans;

* issue convertible bonds;

* issue ordinary shares.

Compared with the theory of Modigliani and Miller, Myers softened the condition of identity of expectations and allowed the presence of asymmetric information among different market participants. According to the theory of sequence of actions, there is no definite optimal balance between debt and equity. The capital structure ratio changes when the balance between the generated cash flows and the real investment opportunities of the company is disturbed. Within one industry, all firms seek to maintain the same level of investment in order to maintain competitive positions.

To make these investments, high-profit firms have the opportunity to use internal resources, and those firms that do not have enough internal resources are forced to resort to debt financing. Therefore, the debt ratio is determined by the level of profitability and investment opportunities of the company. Profitable firms that do not have significant investment opportunities are gradually reaching a low share of debt in the capital structure. On the contrary, firms whose investment opportunities exceed domestic sources of financing, gradually increase the proportion of borrowed capital. Why does the hierarchy of sources of funding look that way? One of the possible reasons is that the use of internal sources allows you to avoid transaction costs associated with the issuance of securities, and the costs associated with issuing bonds, less than the costs of issuing shares.

However, the emission costs themselves are not so significant compared with the costs and benefits of financial leverage, considered in the framework of the theory of static interaction. A more important reason is the presence of information asymmetry costs in attracting new capital, which were considered by Myers and Mailuf. [14]

They applied the “plum” and “lemons” market model developed by J. Akerlof to the capital market, designating firms with favorable investment opportunities as “plums”, and firms with less favorable prospects as “lemons”. Managers know about the company much more than external investors. Therefore, they will not want to sell stocks if they are convinced that stocks are undervalued. Conversely, managers will readily sell them to outside investors if they are sure that the shares are overvalued. Investors, in turn, understand that managers know more about the firm and the true stock price than they do. Therefore, when stocks are sold, investors perceive this as a dangerous signal and agree to buy stocks only at a reduced price. Managers agree to sell them only at a fair price. As a result, a situation may arise where the firm will be forced to abandon certain investment opportunities only because managers do not agree to raise equity capital at a high price. Issuing bonds instead of stocks minimizes the informational advantage of managers compared to investors, since bonds are a less risky tool compared to stocks. Moreover, the company must first do short-term borrowing, which are less risky than long-term.