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  • Equitymaster.com : Auto: Unfurling the excise cut!

    Auto: Unfurling the excise cut!

    In the Budget 2006-07, the Finance Minister announced a reduction in excise duty on manufacturing of compact cars (engine capacity upto 1,200 cc (for petrol cars), 1,500 cc (for diesel cars) and measuring upto 4,000 mm in length). In this article, we shall try to understand whether such a reduction in excise is actually beneficial to the auto company and if yes, to what extent.

    A highly taxed sector
    The Indian automobile industry is amongst the highly taxed ones. To put this in perspective, all passenger cars attract excise at 24% (pre-budget), sales tax at 12% (on excise as well as freight, thus creating a cascading effect), road tax in the range of 4% to 11% (rising with car costs) and octroi. Further, with the customs duty on components thrown in, the taxes together account for over half of what a customer pays for a car. Another interesting fact to note is the correlation of a reduction in excise duty with the growth in volumes. (see chart below)

    Companies that are likely to benefit the most are Maruti and Tata Motors (the listed companies). It should be noted that compact cars account for around 75% of the volumes of the passenger car industry. Assuming that the cost of producing a car is Rs 0.2 m and the on-road price is Rs 0.3 m, an 8% reduction in excise will straightway result in an Rs 16,000 reduction in prices (or 5% of the selling price). This is assuming that the manufacturers pass on the entire benefit to the consumers.

    What can be the potential effect of the reduction?
    For the purpose of this article, we have restricted ourselves to the volume numbers of Maruti, as it is the leader in the passenger car segment with a 54% market share. Almost 70% of the company’s total volumes in FY05 were accounted by the compact car segment. Further, we have extrapolated FY05 and FY06 volume numbers to assess the impact of the change in the duty structure. Another assumption is that the company will pass on 80% of the benefits to the consumers. Similarly, as far as price elasticity is concerned, we have relied on the study conducted by National Council of Applied and Economic Research (NCAER). As per its report, the price elasticity is 1.8 times, indicating a change in demand by 1.8 units for a change in price by 1 unit. Thus for a 4% reduction in price of the vehicle, the additional demand should increase by around 7.2%. Translating these into numbers, we get the following picture. Earnings growth (all other things remaining the same) will be augmented by 11% in the case of Maruti (based on FY05 earnings).

      FY05 FY06
    Incremental units 29,066 30,476
    Incremental sales (Rs m) 9,214 10,640
    NPM 7.8% 8.8%
    Incremental earnings 719 936
    No of shares (m) 289 289
    Incremental EPS 2.5 3.2
    EPS (FY05) 29.5 29.5
    % increase in EPS 8.4% 11.0%

    Thus, in our opinion, the excise reduction should benefit the company. This is just a sensitivity analysis and not intended at recommending a stock.

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