Tesco: Case Study - Essay Example

?Tesco: Case Study Introduction Tesco is a UK based Multinational Corporation founded by Jack Cohen in 1919. It deals with groceries and general merchandise. Today in terms of profits, Tesco is the world’s second largest retailer, and the third largest on the strength of revenues. The company has its retail stores across North America, Europe, and Asia. In addition, Tesco is the most leading player in the UK’s grocery market. As stated on the Tesco Plc’s brand licensing website (n.d.), the organisation has noticeably expanded its product lines to several other areas including clothing, electronics, books, furniture, petrol, telecommunication services, and financial services since the early 1990s.Tesco is a FTSE 100 Index constituent and has a strong position in the London Stock Exchange. The company’s corporate history shows that “it had a market capitalisation of approximately ?24.4 billion as of 15 January 2012” (Tesco Plc’s brand licensing, n.d.). This paper will critically analyse Tesco’s financial strategy with respect to the firm’s sources of funds and dividend policy. The paper also recommends an appropriate financial strategy for the organisation. Tesco’s financial strategy In order to analyse the company’s financial strategy effectively, one must evaluate Tesco’s financial performance over the last years. The following chart indicates the firm’s turnover and profit for the last five fiscal periods (2007-11). (Tesco’s turnover, cited in Legan, 2011). From the above figure based on Tesco’s historical financial data, it is evident that the Tesco’s turnover and thereby profit have been consistently increasing over the last five years. At the end of the 2005-06 financial period, Tesco was positioned as the world’s fourth largest retailer behind Wal-Mart, Carrefour, and Home Depot with turnover ?38,300 million and a profit of ?1,576 million. In the following fiscal year, the company improved its position and moved ahead of Home Depot with a ? 1,899 million profit. A fall in the US dollar value against the British pound also contributed to the company’s achievement. Tesco further improved its financial status over the next two accounting periods also despite the adversities of the 2008-09 global financial crises. The company not only effectively survived the global recession, but also made a record profit (?2,336 m) for a British retailer during the 2009-10 fiscal period. Recently in 2010-11, the organisation again improved its financial status by acquiring a turnover of ?67,573 million and a profit of ?2,671 million. On the strength of its strong financial background, Tesco has been progressively increasing its earnings per share for the last decade. Hence, the company is an attractive investment destination for global investors. Tesco’s financial strategy, as specified on its website Tesco Plc Funding (n.d.), indicates that the firm’s operations are financed by “a combination of retained profits, long and medium term debt capital market issues, commercial paper, and bank borrowings and leases” (Tesco Plc Funding). As mentioned in Tesco Plc’s News Release (2008), during the financial year 2007, the company raised ?2,611m from operating activities, and the company used this amount to finance ?3bn in capital expenditure; in the same year, the company transferred its profit of ?1,899m to retained earnings. Tesco issued Medium Term Note (MTN) borrowing worth ?1,213m and cut down its overdrafts, MTNs, and loans by ?108m; and in 2007, the company distributed dividends of ?467m among its shareholders and purchased its own shares amounting ?490m (ibid). Hence, it is obvious that the firm uses different sources of funds and spends huge amounts in capital expenditure with intent to promote rapid growth. As Morningstar reports (Oct 6, 2009), Tesco finances major portion of its capital expenditure through internal funds. Similarly, the organisation always tries to give better rate of returns to shareholders in the form of dividends. Tesco announced a new dividend policy in 2006 “increasing its dividend pay-outs broadly in line with its earnings growth rate” (Early Retirement Investor, n.d.). While analysing the company’s financial statements over the last few years, it is clear that Tesco has increased the rate of dividend payments to its shareholders in accordance with the profitability growth. In order to take advantages of its fast growing business, the company has recently planned to amend its capital structure management policies. Firstly, the Tesco management has planned to use capital from property assets to give back to shareholders and thereby to minimise reliance on equity finance. The organisation strongly believes that this strategy would assist them to offset future dilution of earnings per share and to effectively invest the company’s capital expenditure toward promoting market growth. AsSibun (2011) assumes, the company’s approaches clearly indicate a move toward debt financing practice. This strategy will certainly increase the debt within the Tesco’s capital structure. It will also change the firm’s debt to equity ratio. Wagstyl (2011) reports that Tesco always tends to invest in emerging markets as the company believes this policy would yield more gains. In short, Tesco’s financial strategy is gradually reshaping its capital structure in order for increasing debt finance and for improving the return to equity shareholders. Corporate life cycle theory to Tesco’s financial strategy The corporate life cycle theory is an extensive extension of the product life cycle theory. The corporate life cycle theory embraces ten stages including ‘courtship, infancy, go-go, adolescence, prime, stability, aristocracy, recrimination, bureaucracy, and death’ (cited in Frielinghaus et al, 2005). While scrutinising the corporate status of the Tesco, it is clear that the company is at its prime stage. Scholars like Adizes (2006) opine that prime is the optimal phase on the corporate life cycle; and the organisation achieves a balance between control and flexibility at this position. In this phase, the company can consistently meet customer needs mainly through the application of innovations. Moreover, every factor necessary for organisational success comes together in this phase. Referring to Adizes (2005, p. 11), the organisation is opening new decentralised business segments that would take advantages of new life cycle opportunities. In short, the urge for growth is very strong at the prime phase and therefore Tesco needs to raise more funds here and keep more amount of working capital with it. Therefore, the planned debt financing strategy seems to be effective for the market growth of the company because this change in capital structure would assist the firm to raise more funds whenever required. In addition, the high level capital expenditure strategy also may help the organisation to contribute to its international expansion. Finally, Tesco’s increased emphasis on the emerging market investments would add value to the firm’s long term sustainability because according to the reports, emerging economies like India and China would dominate the world over the next several decades. However, the organisation’s policy of reducing reliance on equity finance is not supportable, because equity financing can have the potential to raise unlimited funds. Corporate finance theories As Bailey (2005, p. 457) observes, the Modigliani-Miller (M&M) corporate finance theory provides basis for the effective capital structure management. According to the propositions of the M&M theory, the capital structure change must not affect the firm’s value; instead the change should improve return to equity. Bandopadhyaya et al (2012) conclude that according to the M&M Proposition I, the capital structure is not dependant on value; whereas with regard to the Proposition II, shareholders may expect improved rate or returns through increased level of debt financing. From the rearrangement of Weighted Average Cost of Capital (WACC) equation (as cited in KPMG International, 2005), the return rate to equity must improve as the leverage increases. Although these propositions may not work properly, improved returns to equity would be balanced by the increased level of risk. It seems that these propositions do not consider costs of financial distress. However, Tesco has updated the Proposition I to include such factors. Those additionally included factors intend that shareholders would receive increased return to equity in proportion to debt increases until a level where debt causes high risk of financial distress. Since Tesco has been improving its Interest Cover rates for the last several years, financial distress is less likely to be a threat to the organisation’s foreseeable future. In addition, the organisation maintains a very low debt to equity ratio; hence, shareholders would receive improved returns to equity by transforming the capital structure to a higher debt to equity ratio. While analysing the current financial status of Tesco, obviously the company has little to lose by increasing its debt-to equity ratio. As Sawant (2010, p.78) points out, the Trade-Off Theory reflects that capital structure can be considered as a compromise between advantages of return to equity that are arising out of the tax shield and the financial distress costs. The theory suggests the firms with high taxable revenues and safe tangible assets to maintain a relatively high debt to equity ratio whereas the theory recommends a low debt to equity ratio for smaller growth organisations. Hence, the Tesco’s current financial position and debt to equity ratio do not match with each other. Hence, the Trade-Off Theory supports the proposed capital structure change. The Pecking order theory assists organisations to choose between various financial choices. As Whited (2010, p. 55) comments, the pecking order theory proposes that internally raised funds are the most recommendable form of finance. The theory (as cited in Rasiah & Kim, 2011) considers the asymmetric information flow between managers and stockholders as part of the principal agent- relationship and evaluates the effect of this information flow on the management decision to issue equity or debt. An organisation’s increased focus on equity issuance can be considered as the evidence of its pessimism whereas the issue of debt directly indicates that the firm is very optimistic about its future. Hence, Tesco’s increased dependence on internally generated funds and maintenance of smooth dividend levels are best supported by the pecking order theory. Recommendations The above analysis point to the fact that the company has been converting its assets to capital with intent to preserve the shareholder interests in the long run. Although this policy may assist the company to keep stockholders satisfied in the short term, they are likely to leave the company in the long run. Hence, it is recommendable for the company to increase the leverage and raise the debt issuance level to safeguard the stockholders’ financial interests in the long term. Although many of the corporate finance theories support Tesco’s debt issuance financial strategy, debt financing may sometimes raise serious challenges to the existence of the organisation. To illustrate, referring to Jickling (2003), thoughtless debt financing activities played the central role in the corporate failure of Enron Corporation. Hence, Tesco must be very careful while designing its debt financing strategy because over debt levels would probably take things beyond the firm’s control. Similarly, the company has to consider political, economical, socio-cultural, technological, and environmental factors while investing in emerging economies. For instance, although China is a fast developing economy and an attractive investment destination, the Chinese government has imposed a set of strict restrictions on foreign marketers in order to protect the country’s domestic players. In contrast, India, which is another emerging economy, adopts more friendly approach to foreign corporations. Anyhow, a well structured debt financing strategy will certainly assist the company in various aspects. Referring to Harper (2005, pp.276-277), debt financing strategy may be beneficial for Tesco to retain supreme ‘control over the company affairs’. Hence, the financial strategy would aid the company to avoid unnecessary stockholder interventions. As discussed earlier, since Tesco’s financial position is very strong and the company may not face any difficulty in raising funds from external sources. Furthermore, this financial strategy would not suit a powerful multinational corporation like Tesco because other sources of finance may not be adequate for the organisation to meet huge fund requirements in times of unforeseen contingencies. Conclusion In total, Tesco is a financially feasible organisation with growing profitability status. Currently, the firm uses different sources of funds to meet its operational requirements. Tesco is very much interested in capital expenditure, and most of which is financed through internally generated funds. The company has an efficient dividend policy by which payments to shareholders increased in proportion to the firm’s growth of earnings. In addition, the company has planned to reform its capital structure by giving more focus to debt finance. Finally, the company specifically invests in emerging economies so as to promote its business sustainability and further market growth. References Adizes, 2006. Understanding the corporate lifecycle. [online] Available at: [Accessed 14 March 2012]. Adizes, I. 2005. The Pursuit of Prime. The Adizes Institute Publishing, China. Bailey, R.E. 2005. The Economics of Financial Markets. Cambridge University Press, New York. Bandopadhyaya, A et al. 2012.Corporate financial strategy.University of Massachusetts Boston: Financial Services Forum [online] Available at: [Accessed 14 March 2012] Early Retirement Investor, 2010. Announcement of new dividend policy [online] Available at: [Accessed 14 March 2012]. Frielinghaus, B et al. 2005, Capital structure and the firm’s life stage.South African Journal of Business Management, 36(4), pp. 9-18. Harper, S.C. 2005.Extraordinary Entrepreneurship: The Professional’s Guide to Starting an Exceptional Enterprise.John Wiley & Sons, New Jersey. Jickling, M. 2003. The Enron collapse: An overview of financial issues [pdf]. CRS Report for Congress [online] Available at: [Accessed 14 March 2012]. KPMG International 2005. Western Power Corporation: Weighted average cost of capital [pdf] Energy & Natural Resources [online] Available at: [Accessed 14 March 2012]. Legan, C., 2011. Tesco from the British empire to supermarket imperialism [pdf] Available at: [Accessed 14 March 2012]. Morningstar, 2009.Tesco impresses with first-half results. [online] Available at: [Accessed 14 March 2012]. Rasiah, D & Kim, P.K. 2011. A Theoretical review on the use of the static trade off theory, the pecking order theory and the agency cost theory of capital structure.International Research Journal of Finance and Economics.(63)pp. 150-159. Sawant, R.J. 2010. Infrastructure Investing: Managing Risks & Rewards for Pensions, Insurance Companies & Endowments. John Wiley and Sons, New Jersey. Sibun, J. 08 December 2011. Tesco plans for eurozone break-up. The Telegraph [online] Available at: [Accessed 14 March 2012]. Tesco Plc. Brand Licensing. Tesco: Brand detail. [online] Available at: [Accessed 14 March 2012]. Tesco Plc. Funding.[online] Available at: [Accessed 14 March 2012]. Tesco Plc, 2008. News Releaseon Tesco plc preliminary results 2007/08.[online] Available at: [Accesed 14 March 2012]. Wagstyl, S. 2011.Tesco: Asia overtakes Europe. Beyondbrics.[online] Available at [Accessed 14 March 2012]. Whited, T.M. 2010. What can cash shortfalls and windfalls tell us about finance constraints. In G Calacagnini& E Saltari (Eds), The Economics of Imperfect Markets: The Effects of Market Imperfections on Economic Decision-Making, Springer, New York. Read More