What is the security mix in the capital structure

Design of the optimal capital structure taking into account the leverage effect

Table of Contents

List of figures

Symbol directory

1 Introduction

2 Financial principles and definitions
2.1 Finance
2.2 external and internal determinants of corporate finance
2.3 The basic characteristics of equity and debt
2.4 Forms of financing
2.5 Funding Rules
2.5.1 static funding rules
2.5.2 dynamic funding rules

3 The optimal capital structure
3.1 Characteristics of the capital structure
3.2 Risks to the capital structure
3.3 Optimizing the capital structure
3.4 Basic models of capital theory
3.4.1 The traditional model
3.4.2 The Modigliani / Miller theorem

4 leverage effect
4.1 Definition and restrictions of the leverage effect
4.2 Symbols and derivation of important key figures
4.3 Clarification of the leverage effect using a practical example
4.4 Leverage Opportunity and Leverage Risk
4.5 critical assessment of the leverage effect

5 conclusion

bibliography

List of figures

Figure 1: Important determinants of capital requirements

Figure 2: The basic characteristics of equity and debt

Figure 3: Forms of financing

Figure 4: static funding rules

Figure 5: Representation of the thesis of the optimal level of indebtedness

Figure 6: Modigliani-Miller cost of equity decline

Figure 7: Symbols for the leverage effect

Figure 8: Capital structure and return on equity

Figure 9: Example of leverage effect

Figure 10: Effect of debt on return on equity

Symbol directory

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1 Introduction

Maintaining financial equilibrium is a condition of existence for every company (cf. Wöhe et al. 2009: 35). A company's financial equilibrium is massively disturbed when it can no longer meet its obligations to creditors. If this occurs, the creditors can assert legal claims which, in the worst case, can lead to the dissolution of the company in insolvency proceedings. It is therefore imperative that the basic requirements of financial equilibrium are met at all times. One of these basic requirements is the determination of the optimal capital structure. The aim is to generate an optimal ratio of equity to debt. An essential component in this context is the leverage effect, which creates a connection between profitability, risk and debt of a company (cf. Volkart 2011: 596). According to this, "the return on equity rises as the proportion of borrowed capital increases, as long as the return on the capital employed is greater than the borrowed capital rate" (Klinker 2010: 31).

The aim of this thesis is to analyze the capital structure with regard to the leverage effect. First of all, a basic understanding of the financing rules, the optimal capital structure and the leverage effect should be conveyed. Ultimately, these fundamental aspects should be helpful in determining the optimal capital structure.

At the beginning of the work, an insight into the financial sector with its numerous forms and rules of financing is given. The theoretical basics of the characteristics of the types of capital as well as knowledge of external and internal determinants of corporate finance are required in order to be able to competently assess an optimal capital structure.

The third chapter deals with the optimal capital structure as a basis for the further course of the work. Based on the definition of the capital structure, explanations of its risks and optimization follow. Subsequently, basic models of capital theory are presented. The Modigliani / Miller theorem is focused more closely in order to obtain other approaches with regard to the degree of indebtedness.

Chapter four presents the leverage effect as the core content of this thesis. In detail, this takes place through the mathematical derivation of important key figures and the clarification of the leverage effect using a practical example. Furthermore, the restrictions as well as opportunities and risks are examined in detail. Finally, there is a critical assessment of the leverage effect.

A conclusion concludes the work.

2 Financial principles and definitions

2.1 Finance

In our economy based on the division of labor, funds are a necessary prerequisite for maintaining business processes for the provision of services. On the one hand, funds are required to make production factors available. This leads to payouts, and thus means a decrease in liquid funds. On the other hand, through the sale of its products, the company again receives liquid funds in the form of payments. Every company is characterized by such a performance-related value cycle (cf. Lechner et al. 2010: 225; Becker 2009: 3; Klinker 2010: 29).

The purpose of corporate finance is to plan, tax and control payment flows. In order to be able to fulfill this task, the finance industry is divided into three functional areas: financing, investment and financial management (cf. Becker 2009: 3). The financing has to raise the necessary capital. The investment uses the capital raised in the company. Financial disposition or capital management enables the processing of incoming and outgoing payments within the framework of payment transactions (cf. Olfert, Reichel 2008: 20).

In the financial economy a distinction is made between two different theories, the traditional, goods economy financial economy and the modern or decision-oriented. Traditional finance theory deals with the company as an organizational structure and uses a goods and financial cycle as a model. In essence, this is about the question of which financial activities a company should undertake in order to ensure its continued existence in the long term. The modern view, analogous to general microeconomic theory, assumes the rational behavior of all participants in economic life and deals with optimal financing and capital allocation (cf. Geyer et al. 2009: 3 f .; Hildmann, Fischer 2002: 1). The optimal financing and the resulting optimal capital structure will be explained in more detail below.

The main financial goal nowadays is the long-term increase in company value. In theory and in practice, a number of different sub-goals can be derived from this. In the literature, however, the five central financial goals are named: profitability, liquidity, security, growth and independence (cf. Pape 2009: 14 f.).

2.2 external and internal determinants of corporate finance

A company is confronted with a large number of issues and developments that influence its capital requirements (cf. Büschgen 2001: 139). As insolvency analyzes show, knowing and observing these determinants is of great importance when designing corporate finance (cf. Gonschorek, Gonschorek 2008: 12).

"The diverse determinants of capital requirements can best be divided into two main groups" (Busse 2003: 42):

- external determinants
- internal determinants

Each group as well as the individual determining factor within the group can significantly change the amount of capital required. For example, the amount of capital required depends on the prevailing structures of the procurement market, since every company is initially dependent on the purchase of production factors. In the same way, the conditions of the sales market primarily determine the level and course of the capital release (cf. Büschgen 2001: 139). Figure 1 shows the selected determinants of capital requirements.

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Fig. 1: Important determinants of capital requirements (cf. Busse 2003: 43)

2.3 The basic characteristics of equity and debt

The shareholders' equity is made available by the owners as shareholders without any time limit. It can be provided in two ways:

- Equity financing if the owners provide it from outside (share capital, capital reserve)
- Self-financing if the company generates and retains the capital itself (retained earnings, retained earnings)

(cf. Olfert, Rahn 2008: 253; Thommen, Achleitner 2009: 568).

The outside capital, on the other hand, is made available for use by third parties for a certain period of time and thus represents the company's total debts (cf. Olfert, Rahn 2008: 330; Thommen, Achleitner 2009: 568).

Fig. 2 shows the different characteristics of equity and debt capital using eight selected criteria.

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Fig. 2: The basic characteristics of equity and debt capital (Lechner et al. 2010: 301)

The features presented in Fig. 2 are of great importance for the professional assessment of the optimal capital structure (cf. Gonschorek, Gonschorek 2008: 34).

2.4 Forms of financing

As shown in Fig. 3 below, a distinction is made between internal and external financing (legal position of the financier) and between internal and external financing (origin of the capital).

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Fig. 3: Forms of financing (Schäfer-Kunz 2005: 795)

With self-financing, additional capital is provided in the form of a Participation - financing by creating extended or new shareholder rights, or in the form of a Self-financing by waiving profit distributions. Equity financing also represents external financing with equity. In contrast, self-financing is internal financing through equity.

External financing can be provided externally through borrowing or internally through provisions (in particular from long-term pension provisions) (cf. Bieg, Kussmaul 2009: 31; Pape 2009: 34).

2.5 Financing Rules

Financial equilibrium is one of the important prerequisites for the long-term existence of the company and thus also security for investors (cf. Wöhe et al. 2009: 35). A company is in financial equilibrium when

1. solvency is always guaranteed
2. Financing rules and financial policy indicators are complied with
3. Sufficient financial strength and free cash flow are secured
4. an acceptable risk exposure (risk mix) for the company is maintained (cf. Guserl, Pernsteiner 2011: 197-198).

The funding rules are thus one of the determinants of financial equilibrium.

The financing rules relate to the composition of the capital requirement and not to its amount. Basic principles are drawn up which are intended to show which financial resources are used to fund capital under certain conditions (cf. Wöhe et al. 2009: 35).

A distinction is made between static and dynamic financing rules.

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