Ruin Considerations: Optimal Working Capital and Capital Structure

Abstract

At any point in time a firm must decide both the level of working capital consistent with its productive assets and how to finance these assets. Academic theorists in business administration have traditionally approached decision making of the firm on a segmented rather than on a global basis and have been satisfied with developing suboptimizing decision rules. Thus there has been concern about managing working capital and concern about choosing the optimum capital structure, but traditionally the two decisions have not been made jointly. And even if they were made jointly, decisions would still remain in the working capital area involving inventories, credit granting, and marketable securities. This article is an attempt to interrelate working capital and capital structure decisions with working capital used not only as a buffer to avoid ruin but also to affect sales via changing inventory levels and credit policies. The possibility of ruin introduces a discontinuity that precludes perfect elimination of leverage effects via a market. In this article the acquired working capital serves as a buffer against ruin, as well as a means of increasing earnings, while the debt used to finance the working capital increases the size of the fixed payment obligations, and the cost of debt tends to reduce the total earnings of stockholders.