Choice of Appropriate Business Financing for Tesco - Case Study Example

 Sources of finance Executive Summary; According to (Atkinson 251), financing business processes is the most important functions of the managers. This is because finance enables the company to buy and sale stocks of various goods as needed. Lack of adequate finances limits the scope of operations and can impede the growth prospects of the company. This is because lacks of finances prevent most companies from achieving their full operational potential. Therefore, owners and management boards should ensure that their business organizations are supplied with adequate financial resources to take advantage of the market opportunities. Finances are needed by business organizations to acquire business assets as well as run daily activities such as stocking, distributions, payment of wages and marketing. There are various sources of finances. According to (Barrow et.al 275) the source of finances is dictated by various factors such as the size of the business, rate of interest, nature of the business as well as general performance of the economy. To understand more about the sources of finances and its implications, this paper would focus on Tesco. There are various sources of finance. They include shareholder contribution, retained profits, loan stock and borrowings from the commercial banks. Company Background/History; mission and objectives Tesco plc is an international grocery and a retail chain. Jack Cohen founded Tesco in 1919. In 1947, Tesco Stores limited was listed in London Stock Exchange. The company has continued to expand since it was established. The company has continued to make profits especially for the last twelve years. The company mission is “to create value for their customer, to earn customers loyalty”. The vision is to be the leading international grocery and retail chain. Its objectives are to satisfy their customers and create wealth for the company. Tesco has become one of the most competitive retail companies in the world. Tesco is fourth largest retailer after Wal-Mart, Home depot and Carrefour. The company wishes to expand and seek better ways of obtaining business funds to expand. Evaluate how some of the funding method will affect gearing and financial statement Sources of finance According to (Fields 292) the first source of finance is shareholder contribution. This can be in form of new share issues or right issues. A company that seeks finance may sell its shares to the public through the initial public offers. In the case, companies making acquisition of stock market are listed for the first time. Initial public offers are made in various circumstances especially when a company might desire to raise more cash. Rights issues comprises of selling new shares to existing shareholders according to their shareholding in the company. This will be a rights issue. Rights issues is appropriate when new shares being issued might be small compared to the number of shares already in issue. Shareholders are invited to subscribe cash for new shares, according to the proportion of their holdings in the company. In making rights, issue a company set a price lower enough to be able to secure acceptance of shareholders requested to provide funds. However, it should not be too low in order to avoid excessive dilution of the earnings per share. Secondly, Tesco Corporation can source finance for its operations through loan stock. Loan stock is long-term debt capital that a company raises and interest paid to it. The interest is paid half yearly at a fixed rate. Loan stockholders are long-term creditors of the company. Loan stock has a nominal value. This is the debt owed by the company, and interest is paid on the amount stated at the coupon yield. Example here is when a company issues 10%loan stocks, 10%of the nominal value of the stock will be the coupon yield; hence, $100 of stock receives an interest of $10 every year. The quoted rate is gross before tax. Debentures are form of loan stock and legally known as the written acknowledgement of debt that a company must pay in future. It contains provision concerning payment of interest and the eventual capital repayment. Debentures can vary; there are those with a floating rate of interest. In this kind of debentures, the issuer can change coupon rate of interest. This is done according to the changes in market rates of interest. When the interest rates are volatile, it might attract both the lenders and those borrowing. In terms of security, loan stock and debentures are secure. Security can be in the form of fixed charge or floating charge. In fixed charge, security can have relation with specific assets or even group of assets such as land and buildings. The Company has to provide substitute asset for security to be able to dispose or have lenders consent. The other loan stock may comprise a floating charge. The floating charge is on specific company assets that include stock and debtors, whereby incase of default in payment lenders security will be whatever appropriate class of assets the company owns. This is applicable if another lender does not have prior charge on assets. However, the company will be able to dispose off its assets, as it desires unless a default takes place. When default occurs, the lender appoints a receiver who will run the company. Loan stock and debentures are redeemable and are issued for a period of ten years or even 25 to 30 years. When this period ends, they mature and become redeemable at par or values above par. Mortgages are specific type of secured loan. To obtain it, a company uses title deed or long lease property to act as security with an insurance company or mortgage broker. This enables the company to receive loan that is repayable over a spread long period .Organizations that own property that is unencumbered by any charge are able to obtain mortgage up to two thirds of the property’s value. Most companies find debt capital as an attractive source of finance. This is because profits chargeable to corporation tax are reduced by interest charges. Thirdly, Tesco Corporation can finance its expansions through use of retained earnings. Retained earnings are profit re-invested by an organization instead of paying them as dividend to its shareholders.acccording to ( In an organization, the amount of earnings retained within the business impact directly on the amount of dividends. According to (Coles 298), retained earnings are used to finance new investments instead of paying higher dividends and later raise new equity for upcoming investments. The major reasons for using retained earnings are; firstly, in most companies management believes that retained earnings are funds with minimum or no cost as compared to other sources of finance. Secondly, directors of the company determine the dividend policy of the company. In their view, retained earnings are appealing sources to finance investment projects because it has minimum procedures. For example, it can be done easily without the involvement of shareholders or outsiders. Thirdly, issue costs are avoided unlike new shares share or debentures. In conclusion, self- financing through retained earnings should be restricted considering that shareholders require payments of dividends that are reasonable. Bank borrowing is the fourth source of business finance. This is an important source of finance widely used by many companies. Bank lending is mainly short term and medium term. Short term lending is normally in form of overdrafts and short lending. Overdraft is a short-term loan that allow borrower to borrow loans beyond his or her current balance. However, the bank set a limit depending on the financial capability of a company or a person. The interests are higher as compared to other loans. In addition, interest rates vary depending on the amount of cash overdrawn by business organizations on regular basis. Short loans are not given out for more than three years. However, the rate of interest of short-term loans is less as compared to those of an overdraft. Medium term loans lasts for a period of three to ten years. The banks set margins on the interest rates charged on medium term loans. The size of the set margin depends on credit standing and borrower’s risks. A loan can have either a fixed rate or variable rate of interest that are adjusted after every specified period. Smaller companies borrow loans at a margin above the bank’s base rate. This either will be at variable or fixed rate. At variable interest rate, a loan is also referred to as floating rate loan. Longer-term bank loans will at times be available. This is usually for purchasing long-term assets such as properties and loan takes the form of a mortgage. When a business customer requests a loan or overdraft from a banker, several factors will be considered. These are known commonly as PARTS. The explanation of this is; purpose of a loan. Loan request will be denied if the purpose of the loan is unacceptable to the bank. The customers should state exactly how much they would like to borrow. The banker ought to verify when he or she has the ability to do so that the stated amount required to make the proposed investment has been correctly estimated. The customer must have the ability to repay the loan and other associate costs. Traditionally, short terms loans and overdrafts have been offered by banks. Finally, the security that the business provided should be adequate. Source of finance and resulting implications to the Business According to Jorgenson and Landau (420) each source of business finance has various implications that must be considered well in advance to prevent adverse effects to the company. External financing may interfere with total operation of the board. According to Millichamp (464), External investors such as lending institutions demand that companies that borrow money from them should be managed well to enable them get their money back. The operation of the board may be affected when lending institutions demand certain management practices to be introduced to the companies of their borrowers. For example, lending institutions may demand that the company should have professional board management whose directors are both executive and non-executive with some appointed by the investors. Such demands may make management stressful and may cause exodus of key managers and directors who fail to cope up with higher levels of stress. Secondly, in existing businesses, employees should understand that external financing, especially in a company with a high level of borrowings, shows that management will strive to obtain the greatest productivity and workforce commitment possible. However, management's strategy to obtain higher levels of productivity may bring about reorganization and redundancies. Furthermore, some workers will feel the direct requirements of the investors on their working practices. This applies to the finance and accounts department. The employees in the departments are required to work to the investor's financial reporting requirements. Equity investors might also encourage the management to bring about worthwhile employee bonus or share option schemes. This enables employees to share in the success of the business. Lenders and equity investors will require effective management information systems. This will help produce reports reflecting the company's trading performance within fourteen days of every month. In addition, there will be constant review of the business's performance against the plan agreed upon by the company and investors. According to Berry (382), an organization that has sought external funding will be under great pressure, as they are required to maintain cash flow and margins. Cash flow will be critical as it shows company’s ability to pay interest on the funds borrowed. Margins will be important to the company’s profitability that determines shareholders return. According to Chandra (1124), apart from timely information on cash flow and profitability, external lenders and equity investors will also require management to run the business on a tight basis. The management will also be required to conduct a thorough searching of monthly reviews of trading performance. This includes cash flow and margins, which leads to quick action in correcting existing problems in the business's performance. The above processes and activities affect the performance of the business significantly. Finally, external loans would affect the level of company’s profitability. This is because the company will incur cost of capital that will be charged as the company’s expense. Therefore, company should seek for source of finance with moderate interest rates. The source of finance should also be accessible and available when it is needed. An appropriate source of finance for Tesco’s expansion The company intends to expand its retail business to other areas in the United Kingdom to gain from economies of scale. The loan is expected to enhance company’s profitability through improved channels of distribution. Expansion will place Tesco in front of leading retail stores in the global markets. The most appropriate source of finance to Tesco Corporation is medium-term bank loan. Tesco will not have a problem paying back the loan because it has recorded increasing profits for the last ten years and the trend is expected to be maintained in future. Tesco expect to repay the loan in sixty months and seeks fixed interest rates. Medium term loans are applicable because the company does not wish to increase the number of its shareholders. Bank loans are usually available and accessible as compared to other sources of finances whenever it is needed. The above reasons make bank-borrowing choice for many business organizations in the world. Conclusions Choice of business financing is influenced by many factors. Chief among them are ability to repay back the loan, the cost of finances, accessibility of finances, convenience, grace period, repayment period and other incidental costs that relate to the finance borrowed. The management board of the business organizations should always ensure that they seek appropriate financing for their business to ensure that the business is not interrupted. Sources Atkinson, Anthony. Economics Research New sources of development finance. Oxford, UK: Oxford University Press, 2005. Barrow, Colin, Burke Gerard, and Molian David. Enterprise Development: The Challenges of Starting, Growing and Selling Businesses. London, UK: Cengage Learning EMEA, 2005. Berry, Aidan. Financial accounting: an introduction.2nd ed. London, UK: Cengage Learning EMEA, 1999. Chandra, Prasanna. Financial Management.Noida, India: Tata McGraw-Hill, 2008 Coles, Martin. Financial management for higher awards. London, UK: Heinemann, 1997. Fields, Edward. The essentials of finance and accounting for nonfinancial managers.USA AMACOM Div American Mgmt Assn, 2002. Jorgenson, Dale, and Landau Ralph. Tax reform and the cost of capital: an international comparison. Massachusetts, USA: Brookings Institution Press, 1993. http://www.retail-week.com/a-z/top-50-retailers/2009/ 22 April 2010 Read More