B3: Risk and return

What is the risk profile of your company?

As a global entity, Tata Steel is exposed to risks as well as opportunities in equal measure. Recognising this, the Company has a robust Enterprise Risk Management (ERM) framework that allows the organisation to take certain risks in order to be competitive and to mitigate other risks to drive sustainable results.

Strategic risks

Macro environment and global steel over capacity impact operating markets: Long term growth dependent on success of capacity expansion projects, restructuring. Ensure that its plants are equipped with updated technologies in order to serve clients,

secure cost competitiveness and maintain R&D leadership

Operating risks

Supply chain disruptions could increase operating costs. Balancing economic value as well as ecological and societal value Increasing competition and customer expectation Price volatility of raw materials Growth projects and social license to operate

Financing risks

Adverse movements in credit rating and level of indebtedness could affect financial flexibility Impairment of tangible and intangible assets Financing for the Odisha project was a specific risk to the Company given the volatility in the

global financial markets and the availability of credit Volatility in the currency markets can adversely affect the outcome of commercial transactions

and cause trading uncertainties

Legal risks

Regulatory environment & compliance Legal proceedings

Performance profile of Investment in the company

The performance profile of the company is quite uneven. For the major part of the last 15 years, Tata Steel’s share is doing better that Sensex/Nifty. An investor having invested in Tata Steel on July, 2002 would have earned a whopping 1626 % return on selling it on April 2006. But since the later part of 2014, Tata Steel’s stock has been underperforming the Sensex.

Risk in company’s equity and debt

A sharp decline in steel demand in China has battered the finances of global steel makers, exposing chinks in Tata Steel armour. With debt to equity ratio of 2.0, highest amongst its peers the company. At the end of FY15, its consolidated debt was twice the equity (or net worth), and much higher than the industry average of 70 per cent. At 10, the company's gearing ratio (debt to operating profit) is also among the highest in the industry

Return on Equity or ROE tells company stockholders how effectually their money is being utilized or reinvested. It is a useful ratio when analysing company profitability or the management effectiveness given the capital invested by the shareholders. ROE shows how efficiently a company utilizes investments to generate income. Tata Steel return on equity is - 10.5% . Tata Steel is rated below average in return on equity category among related companies.

Cost of Equity and Debt

Cost of Equity = Risk-Free Rate of Return + Beta of Asset * (Expected Return of the Market - Risk-Free Rate of Return)

a) Based on 10-Year Treasury Constant Maturity Rate as the risk-free rate the current risk-free rate is 2.05%..b) Beta is the sensitivity of the expected excess asset returns to the expected excess market returns. Tata Steel Ltd's beta is 1.22.c) (Expected Return of the Market - Risk-Free Rate of Return) is also called market premium. Market premium is 7.5%.Cost of Equity = 2.05% + 1.22 * 7.5% = 11.2%

As of Mar. 2015, Tata Steel Ltd's interest expense (positive number) was ₹44307.9 Mil. Its total Book Value of Debt (D) is ₹688482.35 Mil.Cost of Debt = 44307.9 / 688482.35 = 6.4356%.

WACC = E / (E + D) * Cost of Equity + D / (E + D) * Cost of Debt * (1 - Tax Rate)

= 0.2307 * 11.2% + 0.7693 * 6.4356% * (1 - -69.735%)

= 10.99%

As of today, Tata Steel Ltd's weighted average cost of capital is 10.99%. Tata Steel Ltd's return on invested capital is -7.65%. Tata Steel Ltd earns returns that do not match up to its cost of capital. It will destroy value as it grows.

Capital Structure:

From Year

To Year

Class Of Share

Authorized Capital

Issued Capital

Paid Up Shares (Nos)

Paid Up Face Value

Paid Up Capital

2014 2015Equity Share 2,100.00 972.1

971215439 10 971.22

2013 2014Equity Share 2,100.00 972.1

971215405 10 971.22

2012 2013Equity Share 2,100.00 972.1

971215229 10 971.22

2011 2012Equity Share 2,100.00 972.1

971214450 10 971.21

2010 2011Equity Share 2,100.00 960.1

959214450 10 959.21

2009 2010Equity Share 1,750.00 888.1

887214196 10 887.21

2008 2009Equity Share 1,750.00 731.4

730592471 10 730.59

2007 2008Equity Share 1,750.00 731.4

730584320 10 730.58

2006 2007Equity Share 1,750.00 581.1

580472856 10 580.47

2005 2006Equity Share 600 554.1

553472856 10 553.47

2004 2005Equity Share 600 554.1

553472856 10 553.47

2003 2004Equity Share 440 368.4

367771901 10 367.77

2002 2003Equity Share 440 368.4

367771901 10 367.77

2001 2002Equity Share 440 368.4

367771901 10 367.77

2000 2001Equity Share 440 368.4

367771901 10 367.77

1999 2000Equity Share 440 368.4

367771880 10 367.77

1998 1999Equity Share 440 368.4

367771512 10 367.77

1997 1998Equity Share 440 368.4

368137405 10 368.14

1996 1997Equity Share 440 368.4

368136568 10 368.14

1995 1996Equity Share 440 368.4

368152085 10 368.15

The pressure on steel realisations and cost increases for India’s operations led to a sharp 24 per cent year-over-year decline in Ebitda in FY2015 to Rs 10,100 crore. This pushed Tata Steel’s leverage to 6.8 times, breaching the downward rating trigger.

Beta values of Tata Steel

PeriodLong Term Beta *

Daily - One Month Range

Daily - Three Month Range

Weekly - One Year Range

Weekly - Two Year Range

Fortnightly - Two Year Range

Monthly - Two Year Range

Beta 1.73 2.29 1.93 0.865 1.23 1.11 1.48Mean 379.94 223.88 246.41 343.19 389.87 389.48 389.5Standard Deviation 13.88% 3.43% 3.24% 4.35% 5.16% 6.95% 12.04%

Bottom up beta of Tata Steel

To calculate the bottom-up beta for Tata Steel, the industry average of the financial and operating leverage has to be considered.

Unlevered Industry beta

Average regression beta = 1.16 Average debt-equity ratio = 1.77 Average effective tax-rate = 9.75% Un-leveraged beta = Regression beta/ {1+ (1-tax-rate)*debt-equity ratio} Un-leveraged beta = 1.16/ 1 + (1-.0.0975)*1.77 = 0.44

The above results in the effect of the financial leverage being eliminated. However the effect of operating leverage also needs to be addressed.

Business beta = Unlevered beta/ {1+ (fixed to variable-ratio)} Business beta = 0.44/ {1+ (0.13)} = 0.38

The figure of 0.38 purely reflects the risk of operating in the steel industry without taking into consideration leverage of any sort. This number forms the base from which Tata Steel’s beta will be calculated. As Tata Steel operations are levered (both operationally and financially), the business beta has to be adjusted to capture this difference.

Unlevered beta of Tata Steel (adjusted for its operating leverage)

Business beta = 0.38 Fixed/variable cost ratio = 0.32 Unlevered Beta of Tata Steel = 0.38 * (1+0.32) = 0.50

If Tata Steel had borrowed no money and the whole company was funded entirely by equity, then the beta of the stock would be 0.50. However, the company has a proportion of debt for which its beta needs to be adjusted

Levered Beta of Tata Steel (adjusted for its financial leverage)

Unlevered beta = 0.50 Debt-equity ratio = 0.4 Effective Tax rate = 30.66% Levered beta = Unlevered beta * {1+ (1 - effective tax rate) * debt-equity ratio} (1-tax rate is used in the formula as interest payments are tax deductible).

Levered beta of Tata Steel = 0.50 * {1+ (1-0.30)*0.4} = 0.64

The bottom-up beta for Tata Steel which captures the nature of the business in which it operates, its operating leverage and the financial leverage works out to be 0.64.