Location via proxy:   [ UP ]  
[Report a bug]   [Manage cookies]                

Tata Motors Cost of Capital

Download as docx, pdf, or txt
Download as docx, pdf, or txt
You are on page 1of 10

Tata Motors: - Cost of

Capital
TATA MOTORS: - COST OF CAPITAL

Tata Motors: - Cost of Capital


Background
Tata motors Limited is an Indian multinational automotive manufacturing
company and also a member of Tata Group and headquartered in Mumbai. It is
manufacturing trucks, vans, buses, sports cars and military vehicles.
Tata motors has auto manufacturing plant not only in India in Jamshedpur,
Sanand, Dharwad and Pune but also in whereas other countries such as
Argentina, South Africa, Britain and Thailand. Tata Motors market share in
commercial vehicle business decrease from 54.7% in 2012-13 to 49.2% in
2016-17.
In 2008, Tata Motors acquired the English car maker Jaguar Land Rover,
manufacturer of the Jaguar and Land Rover from Ford Motor Company, which
is considered as a best acquisition in the history of Tata Motors. JLR is
considered as a highest profitable segment for the company.
According to the case, we have to do the detailed analysis of the capital
structure of Tata Motors Limited and estimate the WACC by finding beta, cost
of debt and cost of equity of the company.

P a g e 1 | 11
TATA MOTORS: - COST OF CAPITAL

Five Critical Financial problems


To understand the reason for increasing cost of equity with respect to the
cost of debt.
Despite failure of Tata Nano and making profits through its subsidiary JLR,
Tata Motors has seen the cost of equity capital has been rising from 2007 to
2016 in comparison to cost of debt capital in recent years.
one of the reasons that are responsible for high rise in equity is Macroeconomic
variables where Microeconomic variables are responsible for the cost of debt.
So, it is important to know that how the share price of Tata Motors affected by
these variables.
The cost of debt capital is depended upon the company’s current debts and the
effective rate of interest, the company pays on its long-term liabilities. The cost
of equity for a company depends upon the sensitivity of the market measure by
beta, market risk premium and average risk free rate of the company’s stocks.
The market premium in turn is taken into account considering the return on BSE
Sensex index minus the return on long-term government bonds. Therefore, in
order to understand the reason associated with change of cost in equity capital
as well as cost of debt capital, all the factors need to be studied.

What was the impact of losing market share on the Cost of Capital?

The cost of Capital is summation of equity and debt capital. The cost of capital
serves as a barometer of the external market’s perception of the economy. Cost of
debt is driven more by macroeconomic factors such as the interest rate prevailing
in the market whereas equity reflects the market’s assessment of the company’s
risk and how change in market sentiments affects share price of company.

With Tata Motors losing market share in every segment of Commercial vehicle
consist of Truck and buses and in Personal vehicle, because of legacy product
lines leaking profits due to large discounts and failure of Tata Nano due to poor
performance and design failure, which ultimately impact the brand value and
finally effect the market share of the company. It also changes the beta value
which impact the cost of capital

Why Tata Motors suffer a huge loss as shown in income statement?

Tata entered the commercial market segment in 1954 after forming a joint
venture with Daimler Benz of Germany. In 2012-13 they have a market share of
around 54% in commercial vehicle segment. But after that there is several
decline in commercial vehicle segment which is due to the increase in market
share of other competitors such as Mahindra and Mahindra and also Ashok

P a g e 2 | 11
TATA MOTORS: - COST OF CAPITAL

Leyland. As Mahindra and Mahindra gain a large market share in LCV


Segment.
At the same time, fortune of the company in passenger vehicle segment is not
changing and they are facing several setbacks due to their quality. Acquiring
JLR considered as a one of the best decision which changes the fortune of the
company in premium segment.

Why fixed asset turnover Ratio of Tata Motors decreases in past couple of
years?

Fixed asset turnover ratio represents how well the company is using their fixed
assets to generate sales. Now since fixed asset turnover of Tata Motors
decreases from 3.79 in 2007 to mere 1.41 in 2016. There are several reasons
behind these decline such as

1. Company is overinvested in plants, equipment, or other fixed assets. As


we can see from the balance sheet, the investment in plant, property and
equipment increases in last few years.
2. One of the other reason behind this decline is company not able to deploy
their fixed assets efficiently as some of the segments are not able to
perform well as per the assets deployed.

Is Return on Investment being greater than cost of capital is a lucrative


tool for taking an investment decision?

Cost of capital refers to the opportunity cost of making a specific investment


decision. It is the rate of return that could have been earned if we put the money
in different investment.

One of the major thing that return on investment not take into account is the risk
involved. Suppose if there is high risk involved in such investment, then risk
averse company will not invest in such type of investment even if the company
will get a lower return. There is a possibility that company will lose all its
money as they put its large chunk of money in risky investments.

There is another project in which return will be less but on the other hand risk or
we say standard deviation is less. Then company will go to invest in this type of
project.

P a g e 3 | 11
TATA MOTORS: - COST OF CAPITAL

Analysis and Interpretation

Cost of Debt
It is the interest that company pays on its borrowings.
This is calculated by multiplying interest rate + yield spread of Indian corporate
debt * incremental tax rate. Interest rate is calculated by interest paid during that
year divided by the long term liability of that year. Interest rate came out to be
9-13% from 2007 to 2016 and the corporate tax is around 32-35% for this time
span. Company credit rating has been taken from the exhibit 5. Cost of debt has
shown a varying trend over the years. Its range is from 6.27-8.9%. Some of the
reasons that have led to this are high interest rate (around 13.5%). Cost of debt
is impacted by interest, tax rate and credit rating.
Cost of Debit = (Interest rate+ yield spread of India corporate debt) *
incremental tax rate…………………………………………..(1)
Tax rate is nearly constant whereas yield spread depends on credit rating and for
Tata Motors varies year to year. The proportion of weighted average in to that
of total market value of the company has been nearly constant at around 15.5%.

Cost of Equity
It is theoretically a return that firm pays to its equity investors.
Cost of equity has increased from 21% in 2017 to 24.7% in 2016. One of the
reasons for this is increase in Beta value to 1.44. Cost of equity with respect to
cost of debt increases. Cost of equity is impacted by beta, expected rate of
return and risk free return rate.
Cost of Equity= Rf+β*(Rm-Rf)………………………….(2)
From 2007 to 2016 value of β(Beta) increase from 1.25 to 1.44. This has
resulted in overall increase in cost of equity. Beta (β) captures sensitivity occur
due to both macroeconomic and microeconomic factors. Also, high beta implies
that variations in overall market regularly affects company stock prices, it is this
uncertainty that leads to increase in cost of equity.
Other factors such as Rm-Rf as represented by equation 1 has been kept
constant at 0.1192 and hence does not lead to any variation in cost of equity.
Rf is the risk free return rate which is dependent mainly on macroeconomic
factors such as repo rate etc. and hence it is usually not much varied.

Beta Value
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio
in comparison to the market as a whole.
A beta of less than 1 means that the security is theoretically less volatile than
the market. A beta of greater than 1 indicates that the security's price is

P a g e 4 | 11
TATA MOTORS: - COST OF CAPITAL

theoretically more volatile than the market. For example, if a stock's beta is 1.2,
it's theoretically 20% more volatile than the market.

Debt/Equity Ratio
It represents how much debt a company is using to finance its assets relative to
the amount of value represented in shareholders' equity.
This has increased from 0.56 in 2007 to 1 in 2016. This increased could be due
to the company expansion which might have led to increase in long term
liabilities taken by the company to finance the expansion.
The share of equity in the total liability has decreased, while at the same time,
the proportion of Total debt has increased. This shows that, from the years 2007
– 2016, the company has raised more money by taking debt rather than raising
capital via equity.
The company’s total liability has increased by nearly 900% in the period of ten
years.

Weighted Average cost of equity


This is calculated by multiplying cost of equity with ratio of equity to total
liability. This has varied from 11-13% in the ten-year period. Similarly, the
weighted average cost of debt is calculated by multiplying the cost of debt with
the ratio of debt to total liability. This has varied from 2-4.66% for the same
period

Weighted average of cost of capital


This is the summation of weighted average cost of equity and weighted average
cost of debt. This has been continuously increasing from 2007 -2016. The net
increase from 2007-2016 is nearly ten times.

WACC= (1-Tc)rdD/V + reE/V= cost of debt+ cost of equity……………(4)


Total Risk
It is known that
Total Risk = Systematic Risk + Unsystematic Risk…………………(5)
The systematic risk of Tata Motors increases from 6.67% in 2007 to 10.01% in
2016, whereas the unsystematic risk is almost constant at a rate of 3.29% during
the same time period. This increase can be attributed to macroeconomic factors
such as the recession of 2008 felt across all nations.
Hence, it can be seen that the total risk for Tata Motors has also increased
during the time period of 2007-2016.
Unsystematic has increased from 2.25-3.29% due to various reasons such as
acquiring JLR and huge loss occur for their investment in TATA NANO
project.

P a g e 5 | 11
TATA MOTORS: - COST OF CAPITAL

Systematic Risk
The risk inherent to the entire market or an entire market segment. Systematic
risk, also known as “undiversifiable risk,” “volatility” or “market risk,” affects
the overall market, not just a particular stock or industry. This type of risk is
both unpredictable and impossible to completely avoid. It cannot be mitigated
through diversification, only through hedging or by using the right asset
allocation strategy.

Unsystematic Risk
Company- or industry-specific hazard that is inherent in each investment.
Unsystematic risk, also known as “non-systematic risk,” "specific risk,"
"diversifiable risk" or "residual risk," can be reduced through diversification. By
owning stocks in different companies and in different industries, as well as by
owning other types of securities such as Treasuries and municipal securities,
investors will be less affected by an event or decision that has a strong impact
on one company, industry or investment type. Examples of unsystematic risk
include a new competitor, a regulatory change, a management change and
a product recall.

Reasons for why the WACC varies widely over the period.

1. Changing levels of debt to equity ratio: -These changes coupled with the
respective changes in rates demanded by investors and creditors can lead
to wide changes in periodic WACC.
2. Diversification in various segments: - As company dealing in various
segments such as from economical, luxury to heavy commercial vehicles.
So there is a case that in some segment volatility is high than the other
segment. So overall cost of capital may change depending upon the
segment volatility.
3. Credit rating: - credit rating of TM over the years as a result of which the
spread of debt over the government bond changes. This also results in a
change in WACC, which can sometimes be drastic.

Recommendations

P a g e 6 | 11
TATA MOTORS: - COST OF CAPITAL

1. Product Improvement: - Tata Motor has to improve their product in terms


of quality so that they can increase its sale which ultimately leads to
improve the asset turnover ratio of the company. It also provides a good
perception in the mind of stakeholders.

2. Beta Value: - Company have to reduce their debt to reduce the effect of
volatility. Since high volatility causes a large increase in the beta value.

3. Diversification:- Company should have to diversify their risk in different


segments they are currently operating such as passenger, commercial and
heavy vehicle segment.

4. Credit Rating: - One of the most prominent factor that company should
focused.

5. Over discounting the future cash flows is wrong. The discounting method
is so designed that it adjusts for risk/period. So for an investment that is
done for two years the certainty value is lesser than that done for one
year. So discounting rate should not be tampered.

EXHIBIT 1

P a g e 7 | 11
TATA MOTORS: - COST OF CAPITAL

Exhibit 1: Cost of Capital Estimate for Tata Motors Group

Year Cost of Debt Cost of Equity Cost of Capital


2007 7.14% 21.6126198 15.54
2008 8.87% 19.54413769 15.36
2009 7.11% 22.2985852 16.95
2010 8.90% 23.5479248 16.53
2011 8.48% 23.32786913 16.13
2012 6.28% 24.12803125 16.17
2013 7.33% 24.36048624 15.87
2014 8.00% 24.38368002 14.81
2015 6.83% 24.41505457 15.14
2016 6.31% 24.77349667 16.41

EXHIBIT 2: CALCULATION OF COST OF EQUITY


YEAR Beta Risk free return Market return cost of equity
2007 1.26 6.62 11.92 21.6
2008 1.06 6.87 11.92 19.5
2009 1.29 6.98 11.92 22.3
2010 1.39 7.02 11.92 23.5
2011 1.36 7.13 11.92 23.3
2012 1.41 7.27 11.92 24.1
2013 1.43 7.36 11.92 24.4
2014 1.42 7.45 11.92 24.4
2015 1.42 7.52 11.92 24.4
2016 1.45 7.54 11.92 24.8

EXHIBIT 3:- CALCULATION OF COST OF DEBT


YEAR interest interest rate tax Credit rating cost of debt
P a g e 8 | 11
TATA MOTORS: - COST OF CAPITAL

2007 465.3 10.81 33.99% 1.68% 7.14


2008 1049.5 13.41 33.99% 2.17% 8.87
2009 2386.6 10.74 33.99% 2.02% 7.11
2010 2855.3 13.48 33.99% 0.86% 8.90
2011 2469.07 12.54 32.44% 1.50% 8.48
2012 3373.69 9.27 32.45% 1.76% 6.28
2013 4665.5 11.09 33.99% 0.61% 7.33
2014 6170.5 12.12 33.99% 0.63% 8.00
2015 6306.9 10.43 34.61% 1.11% 6.83
2016 5703.9 9.63 34.61% 1.06% 6.31

P a g e 9 | 11

You might also like