Optimization of a firm's capital structure: A quantitative approach based on a probabilistic prognosis of risk and time of bankruptcy

Abstract

This article develops a new probabilistic approach to the problem of optimization of a firm's capital structure. The main idea of the approach is straightforward. As a possible firm's bankruptcy is the principal factor restricting the amount of borrowed capital, we assess the probabilities of bankruptcy at various time horizons in the future dependent on the proportion of debt capital and other indices of a firm's current financial position and then calculate how these probabilities influence the firm's value. We identify a set of factors determining conditions of existence and the value of the optimal debt/equity ratio. These include the characteristics of a firm's debt (proportion of short-term component of the debt, cost of service, and maturity horizons of long-term component), characteristics of a firm's ability to pay the debt, and some macroeconomic factors. We represent dependencies of optimal debt/equity ratio and gains in a firm's value on the main influencing factors. The approach is based on real data of real firms and does not use superfluously formalized models. We believe it can be used in practical capital structure decisions although specific calculations must be fulfilled for each firm that needs such decision.