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TATA MOTORS : COST OF CAPITAL

Submitted by Atif Raza Akbar B17012

Tata Motors: Cost of Capital

Case Background

Atif Raza Akbar

BM-A (17012)

Tata Motors, an automotive company founded in 1945, is involved in the manufacture and selling of automotive vehicles. The case begins with Debarshi Konar, the business analyst at Tata Motors, analyzing the estimation of cost of capital and the methods used for the same at Tata Motors. Cost of capital is a very important metric used by both company insiders as well as potential investors to analyze how the company and its divisions are performing with respect to the market. Cost of capital is also used internally to evaluate new investment proposals as well as to measure corporate and divisional performance.

Tata Motors employs the Capital Asset Pricing Model to compute the cost of equity and then combines it with the cost of debt to finally evaluate the weighted average cost of capital. Debarshi observes that the cost of equity has been increasing relative to cost of debt over the past few years and wishes to get to the root cause of this increase. Also he wishes to evaluate WACC and estimate it for the coming year.

Critical Financial Problems

1. Variation in the values of WACC - Debarshi has observed a generous amount of variation in the values of WACC over the years of Tata Motors, as calculated from the historical data available to him. Especially in the years 2007, 2008 and 2009, the weighted average cost of capital varied drastically. It is important to understand what triggered this variation, and more importantly, if it was attributable to factors inside the company or to macro-economic factors. A predictable WACC would be a more attractive proposition for any potential investor, irrespective of whether he is a prospective lender or a shareholder.

 

2007

2008

D/V

0.36

0.41

E/V

0.64

0.59

Cost of Capital

30.26%

23.51%

Tata Motors: Cost of Capital

Atif Raza Akbar

BM-A (17012)

From the above table, we can observe that Cost of Capital was very high in the Year 2007 and 2008 when the weightage of equity was close to 60-65% whereas in the years following 2008 the weight of equity dropped to 50-55% leading to a sharp decline in the cost of Capital.

2.

Evaluating the market risk premium and the betafor Tata Motors is a task which can be approached in multiple ways. Especially when monthly market index data are available, there is a decision to be made in how to calculate the market returns. Whether we take the average monthly return for the 12-month period or simply take the historical return by taking the difference in the starting and closing value of the index for the given period.

Also, in case one adopts a historical return a decision has to be taken regarding whether you go for a moving averages method or the complete historical return for every period.

3.

Estimation of the market or present value of equity and debt? Since the cost of capital involves taking the weighted average of the cost of capital and the cost of equity, it becomes an issue of paramount importance to ensure the accuracy of the debt and equity ratios for the time period that the calculation is being made. Once one has computed the cost of equity, one has to compute what ratio of total value of assets is contributed by the overall equity of the company; i.e., the equity-to-value(e/v) ratio. Equity is represented in the balance sheets on book value, while market value of equity for a well-established company is usually several times the book value. It becomes a dilemma on whether to take the book value of the equity component of the balance sheet or to try and compute the present market value for ascertaining the weighted cost of equity. Calculation of cost of debt then becomes a matter of simplicity as the weight of debt is residual in this

scenario[d/v=1-(e/v)].

4.

The variation in credit rating of Tata Motors over the years in the given period.

It may be observed that the long term credit rating of the company has seen a lot of variation in the recent years, when compared to a period between 2003 and 2010, when Tata Motors was awarded the highest credit rating (AAA) in

Tata Motors: Cost of Capital

Atif Raza Akbar

BM-A (17012)

all years but one. This variation is unwelcome for a company of such stature and standing as Tata Motors as it casts doubts upon the debt-repaying capabilities of its owners and is a problem that might lead to difficulties in the financing of the company in the future. The management needs to have a look at whether these fluctuations are being caused by internal factors within their control. Isolating reasons for the changes in these ratings are important from a corporate financing point of view.

5. Cost of equity vs. Cost of capital

Cost of equity has been decreasing over the years but is still higher than the cost of Debt. This makes it difficult for the senior management to decide on debt or equity as a means for further financing the company. There is also a consistent increase in the Debt to Equity ratio signaling towards the fact that Tata Motors has been funding its expansion through debt.

Analysis and interpretation

In order to arrive at possible solutions to the above problems the first step is to calculate the cost of capital for every financial year from 2007 to 2016 and observe the trends. Cost of capital is defined as expected return on a portfolio of all the company’s existing securities. That portfolio usually includes debt as well as equity. Thus the cost of capital is estimated as a blend of the cost of debt and the cost of equity.

1. Cost of equity

Cost of equity is the expected rate of return demanded by investors in the firm’s common stock. Tata Motors used the Capital Asset Pricing model to evaluate cost of equity.

The CAPM says that

cost of equity(r e ) = expected rate of return = r f +*(r m -r f )

Tata Motors: Cost of Capital

Here,

Atif Raza Akbar

BM-A (17012)

r f is the risk free rate which is the theoretical interest rate that would be paid by an investment with zero risk.

The quantity (r m -r f ) is the market risk premium which describes the relationship between returns from an equity market portfolio and treasury bond yields.

With the monthly BSE Sensex index values provided for the given historical period, we assumed it as a proxy for the open market and estimated rm or the rate of return in the open market by taking the historical average of the returns available till the present period.

is a measure of the volatility, or systematic risk, of a security(Shares of Tata Motors) or a portfolio in comparison to the market(Sensex) as a whole

Calculation of r f, (r m -r f ) and

r f is the risk free rate which is the theoretical interest rate that would be paid by an investment with zero risk. A good estimate for the risk free rate is the yield on long term bonds issued by the government as the chances of the government defaulting are close to nil.

In this case, it was calculated by taking the arithmetic average of the provided monthly 10-year Government of India Security yield rates for every financial year.

is the measure of the risk arising from exposure to market volatility. It measures the systematic risk. A beta less than one indicates lesser volatility with respect to the index used for calculating beta. This means that the market and the stock price are not highly correlated. Whereas if the beta is greater than one means that the stock prices are more volatile than the index. Beta is important because it measures the risk of an investment that cannot diversified.

In this case, the Slope function in excel has been used to calculate beta or the correlation between the monthly share return and the monthly BSE Sensex returns. It must be noted that while the Sensex does not give a picture of the market as a whole, it is the closest proxy of the market we have.

Tata Motors: Cost of Capital

Atif Raza Akbar

BM-A (17012)

(r m -r f ) is the market risk premium which describes the relationship between returns from an equity market portfolio and Govt. bond yields. Arithmetic average of monthly returns of historical data of BSE Sensex was used for estimating r m which is nothing but the rate of market returns and then subtracting the risk free return we got the market risk free premium.

2. Cost of debt (r d )

The cost of debt is the opportunity cost of capital for the investors who hold the firm's debt. It is the interest a company pays for its borrowings. It is expressed as a percentage rate. Because interest is deductible for income taxes, the cost of debt is usually expressed as an after-tax rate.

Calculation of WACC

WACC or the weighted average cost of capital is the average rate of return a company expects to compensate all its different investors (Debt or Equity). The weights are the fraction of each financing source in the company's target capital structure. The return of a proposed project is expected to be at least slightly higher than the WACC for it to be considered financially viable.

WACC = (E/V)* r e + (D/V)r d * (1 T c )

where

R e = cost of equity

R d = cost of debt

E = market value of the firm’s equity

D = market value of the firm’s debt

V = E + D

E/V = proportion of financing that is equity

D/V = proportion of financing that is debt

T c = corporate tax rate

Tata Motors: Cost of Capital

Atif Raza Akbar

Possible solutions to key financial problems:

BM-A (17012)

Variation in the values of WACC. As can be observed from the key financial ratios exhibit, the company has undergone a restructuring of its debt-equity structure by reducing the load on debt and raising equity, this might have led to a change in the WACC calculated as it affects the weights of costs of debt and equity in the WACC formula. This would mean that there isnt a major cause of concern as the WACC becomes reasonably stable afterwards as can be seen from the attached exhibit.

Evaluating the market risk premium and the ‘beta’ for Tata Motors Various models are available for calculating the Market return and beta. But with the given data the best way was to use the historical data and calculate arithmetic averages.

Estimation of the market or present value of equity and debt? In this case for simplicity, the Debt to Equity ratio has been used to estimate the values of D/V and E/V.

Market value of equity can be estimated easily but estimating the market value of debt is rather very challenging therefore usually the book value of debt is considered while calculating weights of the WACC.

Therefore, average of market capitalisation data can be used to estimate the market value of equity and book value of debt can be read from the balance sheet to identify D/V ratio for calculation of WACC.

The variation in credit rating of Tata Motors over the years in the given period. Increase in the debt burden could be one of the reasons from variations in the credit ratings. Therefore, there must be a balance maintained between the debt and equity so that the credit rating of the company isn’t affected adversely which leads to increase in the cost of debt for the company.

Debt vs Equity. The major challenge for the senior management is to strike a balance between the Debt and Equity.

From the exhibits on the Financial ratios we can notice that the Debt to Equity ratio has doubled since the year 2005. This is a good sign as cost of

Tata Motors: Cost of Capital

Atif Raza Akbar

BM-A (17012)

debt is always cheaper than the cost of equity. But too much debt could lead to high interest costs which might affect profitability. Therefore, it is crucial for the company to balance between its debt and equity in such a way that the cost of capital remains low and its profitability isn’t impacted due to high interest cost.

Final recommendations

Leveraging the position: In the years when the cost of equity is too high and the company has a good credit rating it must try to leverage this position and raise funds through debt instead of the costlier equity route. Like in the year 2008 when Tata Motors had a AAA credit rating and the cost of equity was 20.79% against cost of debt of 2.72% it should have considered deleveraging its positions in equity and raising capital via debt.

Determine an optimal structure that works for the company. This means identifying the right mix of debt and equity capital that provides needed funds in the most cost-effective way. Both debt and equity financing involve some form of payment for the privilege of accessing funds. Most large businesses use the weight average cost of capital formula, or WACC, to determine what combination of debt and equity costs the least. While neither debt nor equity can be said to be more important than the other in this calculation, the difference between the typical cost of debt versus equity financing is crucial.

Debt financing is cheaper than equity financing as a rule. Payments on debts, are required by law regardless of business performance, so the risk to lenders is minimal. On the other hand, equity financing is generated by the sale of stock to shareholders. These investors only receive return on their investment, in the form of dividends, if the company turns a profit. The risk to shareholders is therefore much greater than it is to lenders, and the typical cost of equity capital reflects that increased risk. In this way, equity financing has a larger impact on the overall cost of capital than debt.

Further reducing the impact of debt capital relative to equity is the corporate tax rate. Payments on debt are generally tax deductible, which decreases a business' total taxable income. This reduced tax burden can make debt financing even more appealing.

Tata Motors: Cost of Capital

Exhibits

Atif Raza Akbar

BM-A (17012)

 

Exhibit 1

 

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Risk Free Return

7.78%

7.89%

7.56%

7.26%

7.92%

8.44%

8.19%

8.43%

8.28%

7.73%

Yield Spread

1.68%

2.17%

2.02%

0.86%

1.50%

1.76%

0.61%

0.63%

1.11%

1.06%

Rd

9.46%

10.06%

9.58%

8.12%

9.42%

10.20%

8.80%

9.06%

9.39%

8.79%

Rm

36.40%

33.60%

21.70%

27.81%

25.92%

22.10%

20.80%

20.57%

20.79%

18.56%

Beta

1.26

1.06

1.29

1.39

1.36

1.41

1.43

1.42

1.42

1.45

Re

43.77%

35.24%

25.73%

35.76%

32.38%

27.75%

26.18%

25.67%

26.01%

23.39%

D/V

0.36

0.41

0.49

0.52

0.48

0.45

0.46

0.45

0.51

0.5

E/V

0.64

0.59

0.51

0.48

0.52

0.55

0.54

0.55

0.49

0.5

Corporate Tax rate

33.99%

33.99%

33.99%

33.99%

32.44%

32.45%

33.99%

33.99%

34.61%

34.61%

Cost of Debt

2.25%

2.72%

3.10%

2.79%

3.05%

3.10%

2.67%

2.69%

3.13%

2.87%

Cost of Equity

28.01%

20.79%

13.12%

17.16%

16.84%

15.26%

14.14%

14.12%

12.74%

11.70%

Cost of Capital

30.26%

23.51%

16.22%

19.95%

19.89%

18.37%

16.81%

16.81%

15.88%

14.57%