CA INTER FM CAPITAL STRUCTURE LECTURE NO. 1 BY PROF. NITIN

Name: CA INTER FM CAPITAL STRUCTURE LECTURE NO. 1 BY PROF. NITIN
Uploaded: 2023-08-09T18:21:45.000Z
Duration: 3 h 30 min 48 s

Cost of Capital and Company Structure

Overview of Cost of Capital

The discussion focuses on the cost of capital, emphasizing its importance in designing a company's capital structure and financial decisions.

It highlights how to calculate the cost associated with different sources of funds and how to arrange these sources effectively.

Leverage Concept

An example is provided comparing leverage to driving a car, where shifting gears allows for increased speed with less effort.

This analogy illustrates how leveraging can enhance profitability by optimizing resource use.

Capital Structure Theory

The theory behind capital structure involves combining various sources of finance to meet a company's required capital needs.

Key components include equity share capital, loans, and debentures, which must be strategically combined for optimal results.

Factors Influencing Capital Structure

The discussion categorizes financing sources into two main types: debt and equity.

It emphasizes that the proportion of debt versus equity will depend on three major factors: cost control, risk assessment, and overall financial strategy.

Optimal Capital Structure

An optimal capital structure minimizes costs while managing risks effectively; it aims for neutrality between these factors.

The conversation notes that focusing solely on cost without considering other factors like risk could lead to poor decision-making.

Equity vs. Debt Considerations

Equity costs are influenced by shareholder expectations and associated risks, while debt costs are more predictable but come with their own risks.

A balance between debt (which may dilute control but offers tax benefits) and equity (which carries higher risk but maintains control) is crucial for an effective strategy.

Primary Objective in Structuring Capital

The main goal in deciding on a capital structure is wealth maximization—enhancing the market value of the organization through strategic source selection.

Major Theories in Capital Structure

Four major theories are introduced: Net Income Approach, Operating Income Approach, Traditional Approach, Modigliani-Miller Proposition (with/without taxes), setting the stage for deeper exploration into each theory's assumptions.

Understanding Capital Structure and Investment Strategies

Total Assets and Earnings Rate

Discussion on the relationship between total assets and the rate of earnings, emphasizing how these metrics are interconnected in financial analysis.

Degree of Leverage

The degree of leverage can significantly alter perceptions of total assets. It is crucial to understand how leverage impacts the rate of earnings on assets.

Capital Formation Changes

An example illustrates investing 100 crores in capital, highlighting that changes in capital structure do not affect total asset value directly.

If a company raises 30 crores through debt, it does not change the total asset value but alters equity by paying off shareholders.

Investment Strategy Insights

The discussion focuses on why raising debt is strategic for changing capital structure rather than merely increasing investment amounts.

Emphasizes that discussions around capital structure should focus on combinations rather than additional investments or profits generated from them.

Practical Implications of Debt and Equity

To maintain a balanced capital structure when increasing debt to 50%, equity must also be reduced proportionately to keep total capital constant.

Discusses using raised funds from loans to buy back equity shares, thus altering the equity capital structure without increasing overall funds available for business investment.

Different Capital Structures Analysis

Various options for raising funds (100% equity, 70:30 ratio, or 50:50 split between debt and equity) are analyzed for their advantages and disadvantages in terms of capital structure.

Return on Total Assets

Regardless of the chosen capital structure, a consistent return rate (20%) is expected on total assets valued at 100 crores.

Corporate Tax Considerations

Assumption regarding corporate tax neutrality is discussed; while taxes vary across companies, this assumption helps maintain focus during theoretical discussions about capital structures.

Impact of Debt Interest Tax Benefits

Highlights that interest payments on debts provide tax benefits which make debts more attractive compared to fluctuating costs associated with equity financing.

Dividend Payout Policies

A policy where all earnings are distributed as dividends (100% payout), indicating no retained earnings within the company. This affects internal funding sources significantly.

Concludes that such dividend policies lead to equal distribution among fund providers without retaining any earnings for reinvestment purposes.

Market Valuation Linkages

Discusses theories linking assumptions about market valuation with corporate capital structures; emphasizes understanding where investments come from as critical for future profitability assessments.

This structured overview captures key insights from the transcript while providing timestamps for easy reference.

Investment Strategies and Market Valuation

Cost of Capital vs. Investment Returns

The source of funding may be expensive, but if the investment yields higher returns, the origin of funds becomes less significant.

Taking a loan at 20% interest is questioned; if the investment return is 40%, then the cost of capital (12%) becomes irrelevant in comparison to potential gains.

Capital Structure Theories

Two schools of thought exist regarding capital structure: one argues it affects market valuation while the other claims no relevance exists between cost of capital and market valuation.

The first group believes lower costs lead to higher market valuations, while the second asserts that valuation depends on strategic investments rather than just cost considerations.

Approaches to Financial Theory

Different theories have been validated through various assumptions; each theory has its own justification based on practical applications.

Assumptions about corporate tax impact are discussed, leading to modifications in existing theories like net income approach.

Net Income Approach and Traditional Theory

The net income approach suggests that financial leverage does not always remain relevant; thus, new theories were developed to address this gap.

Important formulas related to weighted average cost of capital (WACC) are introduced for better understanding.

Equity Valuation Insights

Equity value is linked to capitalization of earnings; overall cost should be compared against earnings for accurate assessment.

A formula for equity weight calculation is presented, emphasizing how net income available per equity shareholder influences overall valuation.

Financial Leverage Implications

Financial leverage increases can lead to reduced average costs of capital, positively impacting market value for both equity and firm as a whole.

This theory focuses on net income relevance and emphasizes debt interest importance in profit discussions.

Justification for Cost Reduction

Increasing financial leverage within capital structure can lower overall costs due to cheaper sources being utilized more effectively.

Higher proportions of cheaper financing options yield benefits across all areas, enhancing product profitability and shareholder returns.

Capital Structure and Cost of Equity

Increasing Proportion of Debt in Capital Structure

The discussion begins with the idea that increasing the proportion of cheaper debt in a company's capital structure can lead to a reduction in total cost.

The approach concludes that an increase in debt proportion justifies the theory, suggesting that this can be symbolically represented and proven with examples.

Current capital structure is analyzed, focusing on net income and its implications for equity shareholders' earnings.

The valuation of equity is discussed, emphasizing the importance of calculated factors affecting it, ensuring clarity among participants regarding any doubts.

Changes in Capital Structure

A shift towards increasing debt proportion to 30% is proposed while maintaining constant interest rates; calculations are revisited to confirm consistency.

Total assets remain constant despite taking a loan; discussions revolve around how equity should decrease correspondingly when new loans are taken.

If a loan of 10 crores is introduced, equity must adjust accordingly; however, there’s confusion about how much equity remains after borrowing.

Market Valuation Implications

There’s an assertion that if 10 crores are paid back to shareholders through buybacks, market valuation should reflect this change accurately.

Despite paying back 10 crores, market valuation remains at 13.33 crores instead of decreasing as expected; this indicates an increase rather than a decrease in market value post-payment.

Focus on Operating Income

The focus shifts from net income to net operating income (NOI), clarifying that interest costs are not relevant for this analysis.

Emphasis is placed on total running costs rather than individual shareholder earnings; understanding total funding costs becomes crucial.

Risk and Cost Dynamics

An increase in shareholder risk leads to higher costs of equity; expectations from shareholders rise as risks increase due to leverage changes.

Benefits from low-cost debt can enhance leverage but also raise overall risk perceptions among shareholders.

This structured summary captures key insights from the transcript while providing timestamps for easy reference.

Understanding Cost Structures and Benefits in Finance

Impact of Debt on Equity and Interest Rates

The discussion begins with the importance of maintaining a proportional cost when dealing with debt versus equity. A reduction in equity from 80% to a lower percentage is highlighted, emphasizing the relationship between debt and equity.

The speaker notes that by shifting financing from equity (which required a 15% return) to debt (now at 10%), there is a significant financial benefit realized, quantified as a 5% gain translating to ₹10 crores.

Loan Management Strategies

An example is provided where a loan was taken at an interest rate of 15%. By refinancing this loan at 10%, the overall cost of debt decreases, showcasing effective management strategies for reducing financial burdens.

The speaker emphasizes that increasing equity will not necessarily lead to increased market valuation. Instead, it’s crucial to absorb benefits effectively without altering capital structure significantly.

Capital Structure Relevance

It is argued that the combination of debt and equity within capital structure does not directly influence market valuation. This suggests that adjustments in capital structure should be approached cautiously.

A calculation example illustrates how changes in capital structure can affect perceived costs but ultimately maintain constant valuation metrics.

Consistency in Valuation Metrics

The conversation concludes with reiterating that maintaining consistent valuation metrics is essential despite fluctuations in capital structures or interest rates. This consistency ensures stability in financial assessments and decision-making processes.