Program & Batch: PGDM – Ex (2015-16)

Term: IV

Course Name: Corporate Financial Management

Name of the faculty: Dr. Alok Kastia

Topic/ Title : Detailed Analysis of Tata Motors Ltd. by calculating its cost of

capital using CAPM, its Capital structure and Leverages

Original

or Revised Write-up:

Original

Group Members: S. No. Roll No. Name

1 150301007 Tushar Sharma

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Contents1. Executive Summary.............................................................................................................

2. Introduction/Background of the study.................................................................................

3. Conceptual Framework........................................................................................................

Capital Structure................................................................................................................................7

Leverage............................................................................................................................................9

4. Literature Review..............................................................................................................

5. Objective of the study........................................................................................................

6. Scope & Methodology.......................................................................................................

7. Data Collection..................................................................................................................

8. Data Analysis.....................................................................................................................

Capital Structure..............................................................................................................................12

Leverage..........................................................................................................................................13

9. Conclusions & Recommendations.....................................................................................

10. References..........................................................................................................................

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Detailed Analysis of Tata Motors Ltd. by calculating its cost of

capital using CAPM, its Capital structure and Leverages

Executive SummaryThe purpose of the study is to do a detailed analysis of a manufacturing company, Tata

Motors Ltd. In this report, we have calculated the beta, cost of equity and the cost of capital

for Tata Motors Ltd., one of the largest two-wheeler manufacturing organizations in India.

Along with this, we have also studied the capital structure and calculated the degree of

financial and operating leverages of Tata Motors Ltd. for the years 2014-15. Data for

calculating the beta and risk free rate has been obtained from the Ace Equity. To find out the

capital structure and the degree of financial and operating leverage, data has been taken

from the annual report of the company. Beta (daily) for the year 2014-15 of the company is

1.365 while the risk-free rate for the year 2014-15 is 7.9. The cost of equity (Ke) comes out to

be 15.78% for the year 2014-15. The cost of debt (Kd) is 9.5. The weighted average cost of

capital (WACC) is 8.32. The degree of financial leverage (DFL) .966 2014-15 while the

degree of operating leverage (DOL) -2.4 for 2014-15. The degree of combined leverage

(DCL) of the company is -2.32.

Introduction/Background of the study

Tata Motors Limited (formerly TELCO, short for Tata Engineering and Locomotive Company)

is an Indian multinational automotive manufacturing company headquartered

in Mumbai, Maharashtra, India, and a subsidiary of the Tata Group. Its products include

passenger cars, trucks, vans, coaches, buses, construction equipment and military vehicles.

It is the world's 17th-largest motor vehicle manufacturing company, fourth-largest truck

manufacturer, and second-largest bus manufacturer by volume.[3]

Tata Motors has auto manufacturing and assembly plants

in Jamshedpur, Pantnagar, Lucknow, Sanand, Dharwad, and Pune in India, as well as in

Argentina, South Africa, Thailand, and the United Kingdom. It has research and

development centres in Pune, Jamshedpur, Lucknow, and Dharwad, India and in South

Korea, Spain, and the United Kingdom. Tata Motors' principal subsidiaries purchased the

British premium car maker Jaguar Land Rover (the maker of Jaguar, Land Rover, and

Range Rover cars) and the South Korean commercial vehicle manufacturer Tata Daewoo.

Tata Motors has a bus-manufacturing joint venture with Marco polo S.A. a construction-

equipment manufacturing joint venture with Hitachi , and a joint venture with Fiat

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Chrysler which manufactures automotive components and Fiat Chrysler and Tata branded

vehicles.

Founded in 1945 as a manufacturer of locomotives, the company manufactured its first

commercial vehicle in 1954 in a collaboration with Daimler-Benz AG, which ended in 1969.

Tata Motors entered the passenger vehicle market in 1991 with the launch of the Tata

Sierra, becoming the first Indian manufacturer to achieve the capability of developing a

competitive indigenous automobile. In 1998, Tata launched the first fully indigenous Indian

passenger car, the Indica, and in 2008 launched the Tata Nano, the world's cheapest car.

Tata Motors acquired the South Korean truck manufacturer Daewoo Commercial Vehicles

Company in 2004 and purchased Jaguar Land Rover from Ford in 2008.

Tata Motors is listed on the (BSE) Bombay Stock Exchange, where it is a constituent of

the BSE SENSEX index, the National Stock Exchange of India, and the New York Stock

Exchange. Tata Motors is ranked 287th in the 2014 Fortune Global 500 ranking of the

world's biggest corporations.

Table 1

The purpose of this study is to calculate the beta, cost of equity, WACC, degree of financial

and operating leverage for Tata Motors and to find out the capital structure of the company.

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The primary objective is to find out how the cost of equity and the overall cost of capital

affect the capital structure of the company.

Conceptual FrameworkCAPM

CAPM, developed in 1960’s, provides a framework to establish the relationship between the

risk and the expected return for any risky asset. In other words, given the relevant risk for

any asset or security, CAPM model helps investors in ascertaining as to what should be the

expected or required rate of return. This expected or required rate of return is generally used

as a discount rate during the process of equity valuation. Although various alternative

models exist in the market to determine the required rate of return, CAPM is the most widely

used on account of its simplicity and practicability.

CAPM is built on the insight that the market rewards the investors only for systematic risk

(which affects all assets) undertaken and ignores the unsystematic risk (unique risk)

component. In effect, since the unsystematic risk can be completely diversified away by the

investors, required or expected rate of return for a risky asset should be a function of only

systematic risk.

Total risk = Systematic risk + Unsystematic risk

Systematic risk, also known as market risk, affects all risky assets or securities and cannot

be diversified away by the investors. This type of risk is generally attributable to macro

events, such as change in interest rates, inflation, exchange rates, etc. and affects the entire

universe of assets or securities, although in varying degrees. For example, while an increase

in interest rates would affect all securities to a certain extent, impact on rate sensitive sectors

such as banks, auto and infrastructure would be more compared to that of FMCG, pharma

and IT sectors. Similarly impact of an increase in CPI would be more on FMCG and Banking

sectors compared to that of other sectors.

Unsystematic risk, also known as idiosyncratic risk or specific risk, is generally unique to the

industry or a particular company, and can be diversified away completely by the investors.

For example, labour strikes or unrests, product recalls, management change or regularly

upheavals are prime examples of unsystematic risk as they generally affect a particular

company or industry.

To determine the expected or required rate of return on any risky asset, CAPM specifies the

following equation:

Required return on asseti = Risk-free rate + (Equity risk premium) x Betai

Ri = Rf + (Rm – Rf) x βi

Where, Rm refers to market returns, and Rf refers to risk-free rate

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The above equation specifies that the required rate of return on a risky asset is equal to the

return available on a risk-free or riskless investment plus a compensation for risk premium

as measured by the product of Equity risk premium (Rm – Rf) and beta (β).

Equity risk premium refers to the premium investors at a large demand for shifting their

investments from risk-free to risky assets. Higher the risk aversion of the investors, higher

shall be the premium or compensation required for making this shift in allocation (from risk-

free to risky assets). Similarly, beta in the above equation, serves as a measure of

systematic risk. So higher the beta, higher shall be the required return on the risky asset and

vice-versa.

Beta refers to sensitivity or responsiveness of asset (or security) returns relative to that of

the market portfolio or index. Assets having beta greater than 1 are considered to be more

risky than the market and assets having beta less than 1 are considered to be less risky

relative to the market.

Security Market Line (SML) is the graphical representation of the CAPM and specifies the

linear relationship between individual asset’s required or expected return and its systematic

risk. The figure below shows the construction of SML where on the x-axis we have the

systematic risk or beta and on the y-axis we have the expected or required rate of return.

The slope of SML is the reward to risk ratio required by all the investors or the market.

However, given that the beta of market is 1, the slope of the SML is the market risk premium.

Under conditions of market equilibrium, all risky assets or securities should lie on SML to

reflect the appropriate expected return-beta relationship. Consequently, if any asset or

security departs from this equilibrium or appropriate expected return-beta relationship, it may

not be correctly priced. Consequently, all assets or securities lying above the SML are

underpriced or undervalued, whereas those lying below it are overpriced or overvalued.

WACC

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To fund long term projects and assets, firms generally raise capital through various sources

such as equity, debt and preference shares. Each of these sources of capital has a different

cost or required rate of return reflecting varying degree of risk attached to it. WACC

represents the weighted average of the cost or rate of returns required by the equity, debt

and preference shares investors of a company, the weights being the proportion of equity,

debt and preference shares in the total capital of the firm. The expression for weighted

average cost of capital is given by:

WACC = we x Ke + wd x Kd x (1 – t) + wp x Kp

Where

Ke = Cost of equity

Kd = Cost of debt

t = Tax rate

Kp = Cost of preference shares

we, wd, wp = Proportion of equity, debt and preference shares respectively in the capital

structure

The interest payments by a firm are tax deductible, and hence, the cost of debt should be

considered post-tax.

WACC can also be written as:

WACC = (E/V) x Ke + (D/V) x Kd x (1 – t) + (P/V) x Kp

Where

E = Market value of equity

D = Market value of debt

P = Market value of preference shares

V= Market value of the firm (E + D + P)

Capital Structure

The term capital structure refers to the manner in which a firm has financed its business

operations by combining different sources of funds. The main sources of funds available to a

company may be classified into equity and debt sources. Equity refers to ownership capital,

including ordinary share capital and retained earnings, on which the company is not

committed to pay any fixed or pre-decided return. On the other hand, debt or borrowed

capital may take the form of bonds issued by the company or bank loans, on which the

company is committed to pay periodical interest charges as well as repay the principal

amount of debt as per the agreed terms. A third way of raising capital is by issuing

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preference shares which have several features common with debt capital, and is usually

combined with debt sources.

There are certain assumptions on which the theories of capital structure are based:

The company distributes 100% of its earnings as dividends. (As b=0, & g=b*r; so g=0)

The company’s operating earnings are assumed to remain constant in perpetuity.

Business risk of the firm is constant.

Financial risk of the firm changes with debt.

Company issues Perpetual Bonds as debt.

All investors are rational and have same expectations about the company’s future profits.

There are no Income Taxes.

The traditional theory of capital structure says that a firm can increase its total market value

through judicious mix of debt and equity funds. It implies that the cost of capital is not

independent of the capital structure and there is an optimal structure.

The traditional approach implies that as the firm becomes more risky with leverage, although

investors raise the equity capitalization rate, Ke, the increase in Ke initially would not

completely offset the benefit of using cheaper debt funding. As a result, at moderate levels of

debt, the total valuation and share prices increase and the overall cost of capital Ko

decreases.

However, as the proportion of debt increases, beyond some point Ke rises at an increasing

rate with leverage. Moreover, Kd may also rise beyond some point. The optimal capital

structure is the point at which Ko is the minimum. This can be shown in the figure below.

Figure 2

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The horizontal x-axis shows the increasing debt/equity ratio while the y-axis shows the cost

of capital in percentage. As the graph shows, as long as the firm has a low to moderate

proportion of debt financing relative to equity in its capital structure, the advantage could

exceed the disadvantages and the firm may be able to reduce the overall cost of capital.

However, if the firm goes on increasing the proportion of debt financing relative to equity, the

disadvantages would outweigh the advantages and the overall cost of capital starts rising.

At very high levels of leverage, the perceived high financial risk alarms the equity investors

as well as debt providers who demand high risk premium, thus raising the Ke, Kd and Ko.

Thus, firms should try to avoid this type of debt trap and adopt a judicious mix of debt and

equity funds to keep its overall cost of capital low and maximize the value of the firm.

LeverageLeverage refers to the existence of fixed costs in the cost structure of a firm. Fixed costs

may be related to operating activities or financing activities. Leverage has a magnifying

effect on profits so that profits would decline more than proportionately with every fall in

sales and rise more than proportionately with every increase in sales. Fixed costs related to

operating activities create the operating leverage and fixed costs related to financing

activities lead to financial leverage. Thus total leverage of a firm consists of the operating

leverage and the financial leverage.

Literature ReviewCost of capital (CoC) for a company is the cost of its funds (Modigliani, F. & Miller, M. H.,

1958). Funds include debt as well as equity capital. The CoC figures are important from the

perspective of an investor—CoC is the minimum rate of return that an investor expects after

making an investment in the company’s funds. It serves as a benchmark to compare the

worthiness of the investment made. The expected return on the capital invested by an

investor should be at least equal to or more than the CoC. In other words, the CoC is the

rate at which the investment made could earn from an alternative investment of equivalent

risk.

There are two main theories about the capital structure of companies. According to the

trade-off theory, there is an optimal capital structure (Bradley et al., 1984). According to the

pecking order theory, there is no optimal capital structure for every firm (Myers, 1984; Myers

and Majluf, 1984); there is only a hierarchy of financial instruments with increased

information asymmetry via which a firm finances its business activities. Only when all the

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internal modes of financing are exhausted does the firm opt for external financing in terms of

debt followed by equity. Some other comparatively recent theories have been proposed as

alternatives/extensions to these theories, such as the life cycle theory of firm financing and

the market timing theory, which are the latest additions to the capital structure literature. The

direct implication of CoC emerges when an investor wants to value an investment, say an

investment in a project. The CoC serves as the minimum rate of return that the investor

wants to earn from that particular project. However, capital comprises both debt as well as

equity. Thus, in order to determine the CoC, both the cost of debt (CoD) as well as the cost

of equity (CoE) has to be calculated. The cost of debt is calculated based on the interest

obligation of a company. Interest rate calculation differs from company to company

depending on their business and credit rating. Theoretically, interest rate is the risk-free rate

added to the risk premium that is adjusted to the default probability and recovery rate. There

are various methods for calculating the cost of equity. For instance, the dividend discount

model can be used to calculate the cost of equity. However, this approach requires the

estimation of the growth rate of future dividends, which can differ significantly from the actual

growth rate achieved, leading to significant deviation in the calculated and observed results.

Therefore, our study used the capital asset pricing model for the calculation of the cost of

equity. Another important aspect is the capital structure that the company uses while raising

funds; this capital structure governs the CoC. The overall cost of capital or weighted average

cost of capital (WACC) is the weighted average of the cost of debt and the cost of equity.

The primary objective of this study is to find out how the cost of equity can affect the capital

structure of a company and to calculate the degree of financial and operating leverage. To

serve the purpose, we have selected Tata Motors, one of the largest two-wheeler

manufacturing organizations in India.

The values of CoE, CoD and CoC can serve as an important benchmark for an investor who

is new to the Indian market. These values can be used to price his/her debt or equity.

Keeping the overall weighted average cost of capital (WACC) in mind, he/she can also

proportion and organize his/her capital structure (debt and equity) to attain the desired level

of WACC for his/her company, which can be in close proximity to the overall WACC of the

stock index or the particular sector that his/her company falls under.

The review of some of the major studies has been undertaken so as to develop a clear

understanding about the relationship between capital structure and profitability. Chiang et al.,

(2002) undertake a study and the findings of the study put forth that profitability and capital

structure are interrelated; the study sample includes 35 companies listed in Hong Kong

Stock Exchange. Abor (2005) investigates the relationship between capital structure and

profitability of listed firms on the Ghana Stock Exchange and find a significantly positive

relation between the ratio of short-term debt to total assets and ROE and negative

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relationship between the ratio of long-term debt to total assets and ROE. Gill, et al., (2011)

seeks to extend Abor’s (2005) findings regarding the effect of capital structure on profitability

by examining the effect of capital structure on profitability of the American service and

manufacturing firms. The Empirical results of the study show a positive relationship between

short-term debt to total assets and profitability and between total debt to total assets and

profitability in the service industry. The other major studies undertaken by Mesquita and Lara

(2003), Philips and Sipahioglu (2004), Haldlock and James (2002), Arbabiyan and Safari

(2009), Chakraborty (2010), Huang and Song (2006), Pandey (2004) came up with the

findings which were conflicting in nature as some studies confirm positive relationship

between capital structure and profitability while other studies confirm positive relationship

between the variables.

Objective of the studyTo calculate the beta, cost of equity and cost of capital by using CAPM model, leverage and

capital structure for Tata Motors Ltd. Carry out a detailed analysis of the company based on

the outcome for year 2014-15.

Scope & MethodologyFor our study, we have taken the daily share prices and market prices of Tata Motors Ltd.

from the Ace Equity for one year along with the risk-free rate of past 10 years in govt. bond

yield. The daily share prices and market prices were converted into the daily percentage

stock and market returns by dividing the each day’s price with the previous day’s price and

taking the natural logarithm. We calculated the covariance between the stock and market

return as well as the variance of the market return. Hence, daily Beta for Tata Motors was

obtained by dividing the average covariance between stock and market return with the

variance of the market return. This beta was further used to calculate the cost of equity for

the year 2014-15 and the cost of capital or WACC for the company was derived.

To find out the capital structure of the company, we have obtained the net operating income

and the net profits available to equity shareholders from the annual report of Tata Motors

Ltd. and thus the market value of the company as well as the overall cost of capital was

calculated using the traditional theory of capital structure. The implied overall cost of capital

was calculated by dividing the net operating income with the market value of the company.

To calculate the degree of financial and operating leverage, the data was obtained from the

statement of profit & loss of the company in its annual report. The statement of profit & loss

was broken down into the multi-step income statement so that the required leverage can be

found out. The DFL was found out by dividing the EBIT of the company with the EBT of the

company while the DOL was found out by dividing the contribution made by the company

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with the EBIT of the company. Further, the DCL was found out by multiplying the DFL and

DOL.

Data Collection

The data was collected from annual report of Tata Motors for 4014-15 (for balance sheet and

P&L accounts), Ace analyzer, BSE India, Moneycontrol.com.

Data AnalysisBeta (daily) for the stock of Tata Motors is 1.36 for 2014-15

Risk-free rate for the company comes out to be 7.94% for the year 2014-15

Cost of equity for the company in year 2014-15 is -2.74.

WACC for the company is 8.30

Capital Structure

Tata Motors Ltd the overall cost of capital comes out to be 26.19% in the year 2014-15

Particulars TATA MOTARS 2014-15

Net Operating Income (O) 38,176.15Interest for debt (I) 114.285

Profit for Equity Share Holder (P) -3,974.72Cost of Equity (Ke) -0.027499087

Covariance(s,m) 1.080144284Variance (m) 0.791231666Beta Daily 1.36514289

RF (%) 7.9423B (Daily) 1.365143Tax Rate 0.1922

Rm 0.11

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Market Value of Equity (P/Ke) 144540.0736Market Value of debt (I/Kd) 1203

Market Value of Firm (V) 145743.0736Implied Ko (O/V) 0.261941436

Leverage

in Cr.Sales 36,294.74Less Variable Cost 27041.65Contribution 9253.09Less Fixed Cost 13093.79EBIT -3840.7Less Interest 1611.68Other Non-Operating Income 1881Exceptional Items 403.75EBT -3975.13Less Tax 764EAT -4739.13Less Preference Dividend 0Profit available to Equity Share Holder -4739.13Number of Equity Share 3,21,89,00,000EPS -14.72

Degree of Financial Leverage (DFL) 0.966182Degree of Operating Leverage (DOL) -2.40922Degree of Combined Leverage (DCL) -2.32775

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Conclusions & Recommendations

Tata Motors is a non- growth company with its EPS decreasing from 28.55 in March 2011 to

-13.72 in March 2015 (refer the table above). They are not able to pay dividends for the year

2014-15 due to very low EPS. The company has faced a loss of 4738 Cr for the year 2014-

15.

Beta of Tata Motors is more than one 2014-15 which implies that the company is more risky

to invest in its shares than the market. Hence, the investors will not get a risk premium by

investing in the shares of Tata Motors as high as they would get by investing in the market

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portfolio of shares. The cost of equity for the company -2.74 in the year 2014-15. This

implies the returns for investors are next to nothing.

The company has a total debt of 14709 Cr. According to the traditional theory of capital

structure, the optimal structure of a company is one which maximizes the market value of the

company and minimizes the implied overall cost of capital. According to this theory, the

company should have a judicious mix of equity and debt financing. It will raise the cost of

equity but on the other hand, it will decrease the overall cost of capital and increase the

market value of the firm. Therefore, the company should reduce the debt by focusing on

profits. The target of the company should be to increase the EPS and D/E.

The financial leverage of Tata Motors .966 in the year 2014-15 which implies that the

financial risk of the company has increased. On the other hand, the operating leverage of the

company is -2.40 in year 2014-15 which implies that the operating risk of the company is

high. The combined leverage of Tata Motors -2.32 which implies that the leverage is not in

accordance of the capital structure.

References http://www.tatamotors.com/investor/annual-reports/

http://www.tatamotors.com/investors/financials/70-ar-html/profit-loss.html

http://in.investing.com/rates-bonds/india-10-year-bond-yield-historical-data

http://www.aceanalyser.com/

http://www.moneycontrol.com/india/stockpricequote/auto-lcvs-hcvs/tatamotors/TM03

http://www.bseindia.com/markets/equity/EQReports/StockPrcHistori.aspx?

expandable=7&flag=0

http://money.rediff.com/companies/Tata-Motors-Ltd/10510008/ratio

https://en.wikipedia.org/wiki/Tata_Motors