TATA MOTORS : COST OF CAPITAL

Submitted by Atif Raza Akbar – B17012

Tata Motors: Cost of Capital Atif Raza Akbar BM-A (17012)

Case Background

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 ‘beta’ for 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(re) = expected rate of return = rf+*(rm-rf)

Tata Motors: Cost of Capital Atif Raza Akbar BM-A (17012)

Here,
 rf is the risk free rate which is the theoretical interest rate that would
be paid by an investment with zero risk.

 The quantity (rm-rf) 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 rf, (rm-rf) and 

rf 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)

(rm-rf) 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 rm 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 (rd)

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)* re + (D/V)rd * (1 – Tc)

where

 Re = cost of equity
 Rd = 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
 Tc = corporate tax rate
Tata Motors: Cost of Capital Atif Raza Akbar BM-A (17012)

Possible solutions to key financial problems:

 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 isn’t 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 Atif Raza Akbar BM-A (17012)

Exhibits

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%