Tata Steel Capital Structure

Abstract

Generating capital to run the daily operations of businesses is a constant concern for every company. Tata Steel needs money to finance its daily operations and diversify its products to attract high revenues. However, the company must also monitor its leverage to avoid situations that may increase risks for its stakeholders. There is a need, therefore, to investigate the level of leverage that can optimize the shareholders’ value. This analysis offers the criteria Tata Steel can use to raise capital while seeking to optimize the shareholders’ value.

Optimal Level of Financial Leverage

Tata Steel is financed through equity and debt. It is crucial to choose the right proportion of debt and equity that Tata Steel should use to finance its operations because high financial leverage poses great risks to company shareholders. Every company has its optimum financial leverage that can maximize shareholders' value. For instance, some companies opt to operate on equity alone, and others opt to operate on the debt alone. The optimum financial leverage for the company is, therefore, that will maximize the value of shareholders and enhance the operations of the company. If a company over-borrows to finance its operations, shareholders will lose their value. On the other hand, if the company does not have enough money to finance its operations, it will fail to achieve its goals.

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Underlying Factors Considered when Assessing Tata Financial Leverage

To assess the financial leverage of Tata Steel, the following factors need to be considered. First, Sharif must consider the relationship between the capital structure and the company's profits. Compared to equity capital, debt capital is cheaper because of interest deductibles. Thus, the company should take advantage of its high credit rating and increase debt until it reaches the point where marginal benefits from debt are equivalent to bankruptcy costs. When marginal benefits equal the bankruptcy costs, shareholders' value is at its peak. At that point, according to trade-off theory- if the company should stop borrowing and consider more equity if it needs more finances to run its operations. Suppose the company continues to take more debt even when the marginal benefits from debt equal the bankruptcy costs. In that case, the shareholder value will diminish, leading to a loss of value for investors (Aljamaan, 2018)

The second consideration Sharif should employ in determining the level of leverage that will maximize value for shareholders is the company's growth rate (Aljamaan, 2018). The company is in the process of diversifying its products to broaden its client base. To determine the company's capital needs, Sharif may need to look into the plans of the company and the amount of money required to finance all the plans. The ideal mix of capital to run the company should optimize returns while ensuring that the risk the capital mix poses to shareholders is low. The company usually prefers debt capital because of its low cost. However, depending on debt to finance mega projects such as diversification will be risky for the company because of business cycles that may reduce Tata Steel's profits, leading to hardship in repaying its financial obligations.

The third consideration is the median industry leverage. Tata Steel's financial leverage should be within the upper and lower bounds of the industry's median leverage. The financing will not create value for shareholders if the company's financial leverage strays too far from the industry's median leverage. The financing leverage of the peers in the industry is a good yardstick to measure if Tata Steel's leverage is good for investors or if it needs to be restructured to fulfil the company's financial needs and to create value for the shareholders.

Changing Tata Steel’s Financial Leverage

As mentioned, Tata Steel's operations are financed by equity and debt (Manuj, 2022). If the company issues investors more equity, the leverage will reduce. On the other hand, if the company issues more debt to investors, then the company will be highly leveraged. As such, if the management wishes to change the leverage of Tata Steel, then it will either issue more equity or go for more loans. Going for more loans will reduce the company's weighted average cost of capital but expose it to high financial risks. On the other hand, issuing more debt will cushion the company against risks but increase the weighted average cost of capital.

Capital Structure and Tata Steel’s Business Strategy

There is a direct relationship between capital structure and business strategy. The company's free cash flow depends on the cost of capital it pays for financing its operations. The availability of cash flow determines the company’s research and development strategies, acquisitions, and dividend strategies. The capital structure also determines investors’ willingness to invest in the company because the capital structure determines the risk to which the company is exposed. Thus, capital structure has a strong relationship with business strategy.