Academic journal article UTMS Journal of Economics

Application of Cost of Capital for Capital Structuring in Croatian Firms

Academic journal article UTMS Journal of Economics

Application of Cost of Capital for Capital Structuring in Croatian Firms

Article excerpt


Capital structure puzzle is one of the most controversial topics in finance. First theoretical discussion dated from the beginning of 1950s (Durand 1952) was upgraded with more realistic assumptions by Solomon (1963). Neoclassical theoretical approach on capital structure theory was brought by Nobel laureates Modigliani and Miller (1958, 1963 and 1969) whose approach was often called MM revolution. One of two main capital structure theories was developed based on MM approach to capital structure, the trade-off theory (Kraus and Litzenberger 1973). There are many other theoretical approaches to capital structure, as Miller (1977) extension of MM approach with taxes, agency problem approach based on Jensen and Mackling (1976) theory of the firm, information asymmetry approach (Orsag 2011), signaling theory (Akerlof 1970). Classical order of capital stmcture theory finished with second main theory, Myers (1984) and his peeking order theory, originally developed by Donaldson (1961) and popularized by Myers and Majluf (1984), based on managerial preferences according to sources of financing.

Although the trade-off theory is the empirical relevance, such as every other classical theory, it has often been questioned, when and where the management should take the cost of capital into account when establishing capital stmcture for own company. The trade-off is incorporated in the cost of capital between long-term investments and their financing in the companies and limitation of investment horizon of companies through marginal concept and their practical version, incremental cost of capita (Orsag and Dedi 2011). The cost of capital is main tool for capital budgeting decision and therefore is closely connected to the stmcture of financing companies of new and existing investment projects.

In the beginning of 1970s the capital budgeting, especially net present value and other techniques for project ranking came into focus of Croatian academic discussion in the field of business finances. As Croatian firms operated in a quasi-market environment this techniques were discussed without possibilities of the cost of capital establishment. Therefore the discount rate used for discounted net cash flows was determined with the interest rate with or without premium. It can be said that eliminating the cost of capital is the problem of practicing capital budgeting in Croatian companies during long period before transition process which is relatively highly developed (Orsag and Dedi 2008). After transition of Croatian economy and society which occurred in the early 1990s, Croatian companies began assessing the cost of capital as a discount rate for discounting net cash flows in their capital budgeting processes. In the first half of 1950s 76 of 100 surveyed shareholding firms calculated the cost of capital for their capital budgeting decisions, mostly as required rate of return (40) and by using CAPM (40) (Dedi and Orsag 2007). Although the possibilities for calculating the cost of capital as a required rate of return in emerging capital markets such as Croatian may be questionable, the fact is that high percentage of Croatian shareholding companies is calculating the cost of capital.

Starting from frequently used cost of capital in Croatian shareholding companies we shall try to investigate how much the Croatian managers take the cost of capital into account in capital structuring process and how much this practices help to improve performances of their companies. For the first question we expected frequently uses. For the second question we have much more reserve for helpfulness of this practice.


We investigated the intensity of using the cost of capital for capital structuring in Croatian shareholding companies with the questionnaire sent to 100 of 254 Croatian public shareholding companies. The sample of 100 firms was chosen randomly. The respond rate was 73%. This respond rate was unexpected, because the reject rate in Croatia is usually 62 to 73% (Bagic 2004). …

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