Optimal capital structure of Uralkali JSC and Kali&Salz AG

Abstract

This article follows an applied approach: the authors in detail present the steps of finding the optimal capital structure for the Russian chemical company Uralkali JSC, and show the problems that arise from applying the standard approach to emerging markets. The models employed are the weighted average cost of capital, operational income, and adjusted present value model. Furthermore, the authors compare their results to the optimal capital structure of the German competitor Kali&Salz AG and present hypothesis for the observed differences. Also, the authors derive the required return to equity of Uralkali JSC using local, global and hybrid capital asset pricing model (CAPM) devoting special attention to the advantages and shortcomings of each method. From the viewpoint of the authors the most applicable method of calculating the required return to equity is the method of the hybrid CAPM. The greatest disadvantage of the local CAPM is the lacking reliability of the Russian stock market data for the calculation of the risk premium and beta. The greatest problem concerning the global CAPM is the fact that the stock of Uralkal JSC has been traded on international markets (the London Stock Exchange) only since the end of 2007. This renders the application of this approach impossible. At the time of analysis (the December 31, 2007 has been chosen in order to track dynamics during 2008) Uralkali JSC possesses a capital structure similar to that of its domestic competitors: the ratio of total debt to assets based on book values amounts to 36,74%. The weighted average cost of capital model has shown that the optimal level of debt, minimizing the cost of capital, lies in the interval between 30% and 40%. According to the adjusted present value model, taking into account the benefits of the tax shield and the costs of financial distress, the maximum value of Uralkali JSC is reached at a level of financial leverage of 50%. However, it is necessary to add that in the given situation the approach of APV suffers from the questionable statistical meaningfulness of the standard error of EBIT on the basis of only seven historical observations (2001-2007). In sum, at the end of 2007 Uralkal JSC had a capital structure very close to its optimum. In 2008 the analyzed measure of financial leverage fell somewhat to a new level of 35,2%, which also lies in the optimal interval. At the end of 2007 Uralkali’s German competitor Kali&Salz AG possessed a level of debt more than two times higher than its optimum of between 20% and 30% (analogously the authors used the approaches of WACC, Operational Income and APV). The comparison of the optimal capital structures of both companies shows that the optimal level of debt is somewhat higher for the Russian company. This difference rests on the comparatively higher cost of equity for the Russian company and similar cost of debt (accounting for sovereign risk). Key words: optimal capital structure, cost of capital