Corporate Finance at Tesco - Essay Example

of Corporate Finance Introduction This paper consists of two sections. Section will describe the business model and strategies of Tesco and find and connect evidences cited from the case, if any, and explain how they are consistent with corporate objective of maximizing shareholder wealth. Section 2 will assume that Tesco is about to raise £100M for its new project and it considers three financing options: (i) using retained earnings; (ii) offering ordinary shares to the market and (ii) offering a 10 year bond to the market. Using the current financial market data and own assumptions, this paper will calculate the cost of each of the above sources for the purpose of advising Tesco on the choice of financing source. 2.1 Describe the business model and strategies of Tesco by taking on strategy and discuss with evidences cited from the case how it is consistent with corporate objective of maximizing shareholder wealth. Tesco’s business model is for the company to what matters better together as it deliver its core purpose to customers. The core retail activities of insight, buy, move and sell are what the company tries to make better as supported by its strategies, among others, of building the Tesco Brand, Leveraging Group skill and scale, operating responsively, establishing multichannel offer for customers. The financial results measure the performance on how the company was able to accomplish its strategies and objective of wealth maximization. The business model of Tesco includes those made from the perspective of strategic choices. The strategies being used in relation to its business model including that of operating responsibly which include maintaining its good profitability, efficiency management of its assets, acceptable liquidity, balanced gearing ratio and responsive investment ratios. As to whether the strategies are consistent with the corporate objective of maximizing shareholder wealth, it could be said that there is good amount of evidence. The results of the company’s profitability, liquidity, good Solvency , and good investment ratios provide good pieces evidence of meeting the financial objectives of the and which are consistent with the objectives of maximizing wealth of shareholders. Making good strategic judgements has a good way to determining the company’s prosperity and building value for its shareholders over the coming decade. Building shareholder value cannot be done in instant or in short-term. It is actually long-term as it may even be sacrificing in the short-run in order to attain the long-term objective of building value. Good business strategy considers the external and internal environment in making its strategies. The company chairman is aware for the need of present retailers of which the company is a major player of knowing how to position their business relative to rapid and evolving development of the internet, along with the social with the social media. Consumers now have more choices because of these changes in the environment and competition has become global where buyers can now order goods and services from places reachable by the internet. The best evidence of its having accomplished or progressing to its wealth maximization objective is through its P/E low ratio at 8.11 as against industry average of 15.36. Although lower than industry average, this investment ratio is still very high considering the size of the company. This acceptable result of course is caused by good profitability as evidence by return on equity of 14.74% as against industry average of 10.31 for the past five years. Its efficiency as measured in terms of return on assets for the past five years is also higher at 4.84 as against industry average of 4.37. In terms of liquidity, the company can still pay maturing obligations with current ratio of 0.61 as against industry average of 1.06. Its quick asset ratio at 0.44 is still acceptable as against industry average of 0.89, considering that it is in the retail industry where cash flows are quick in turnover. Tesco has also good gearing using debt to equity ratio of 0.76 as against industry average of 0.85. Note that lower gearing is better (“Financials: Tesco Plc”). A profitable company simply means that its revenues are higher than expenses and costs and there is net advantage in entering into business transaction and therefore generating value for the company. Efficiency comes as well with Tesco’s productive way of conducting its activities in the use of its assets. A liquid company must be able to pay maturing obligations on time and must be capable to pay salaries of its employees on time. It does not keep creditors waiting too long by pay accounts payable with on time to allow the latter to delivering goods to be sold to customers. Being good payer means good business and less chance for bankruptcy. As to its good gearing, this is consistent with the requirement to keep the company with balance risk while it maintains debt and equity finance. Companies do have borrowed for additional to investment sometimes or get the money from stockholders. This is however balancing act to do as it could not be there too much debts to make the business too risky in case it would not be able to realize its forecasted level of operation. It would not want to be paying high interest rate because of too much borrowing and it could make the company also not being able to have good cash flow that would in effect affect is liquidity and long-term stability. 2.2 Assume Tesco is about to raise £100M for its new project and it considers three financing options. : (i) using retained earnings; (ii) offering ordinary shares to the market and (iii) offering a 10 year bond to the market. Using the current financial market data and your own assumptions, calculate the cost of each of the above sources and advise Tesco on the choice of financing source. 2.2 (i) using retained earnings The formula and computation is as shown below: Required (or expected) Return = RF Rate + Beta (Market Return - RF Rate) = 0.25% + 0.76 (4.63%-.25%) = 3.58%. To get the cost of retained earnings, there is need to use the Capital Asset Pricing Model (CAPM), which necessitates the need to have the risk free rate and adding the risk premium, or the compensation for assuming the additional risk by the investor. The risk premium is computed by difference of the market rate and risk free rate by the beta as shown in the above formula. The market rate is above is estimating the reciprocal of the industry P/E as an approximation of market and the beta was estimate of the risk of the company’s stock in relation to its other firms and its environment. 2.2 (ii) offering ordinary shares to the market The formula is k= (D1/(P0(1-F)) + g; where: Where D1 is the current dividend per share, Po is the current stock price, g is growth in dividend, and F for the flotation costs or the charges that would be paid to investment banker in helping the set price at a given company structure and for selling the new share By assumed that 5% of proceeds from sale of new shares as floatation cost , the cost of new share is computed at 11.68% as shown below. 2.2 (iii) offering a 10 year bond to the market The highest rate used for its medium term notes in the company’s 2013 annual report 6.125% is used as the before tax cost of debt for Tesco (“Tesco Annual Report 2014” 98). To get the after tax rate this is multiplied by one –minus marginal tax rate of. The marginal tax rate of Tesco of 25.7% based on the ratio of tax to net profit before tax of 2014 (“Tesco Annual Report 2014” 69). Thus the after tax cost of debt is 6.125% (1-25.7%) = 4.55%. 2.3 Which of the three sources of financing is best for Tesco to raise £100 million? The general answer to the questions is to choose which of the three will lead the lowest if the choice will necessarily lead to cost of capital. As computed above, the cost using retained earnings is 3.58%, issue of new shares as computed at 11.26% and after tax cost of debt at 4.55%. The first two are called Equity financing and the use of bonds is called debt financing. Both financing from retained earnings and issuance of new share are called equity financing but the former should be preferred as it is cheaper. The profit for 2014 is £970 million and retained from 2013 to 2014 increase by £807 million. It appear that dividend the same level of dividend pay-out in the previous year and expected £900 million in profit would just go to retained earnings and not everything will be given (“Annual Report of Tesco 2014”). Thus since the cost of financing the same is cheaper and the amount or retained earnings can cover the same, there is no need to issue new share. This is aside from the fact that it would cost higher to issue new share at 11.26%. There will be no need also to issue 10-years bond although the cost is also low at 4.55% but still higher than the cost of just using the retained earnings at 3.58%. The computation of the cost of retained must be understood as using the capital asset pricing model (CAPM) where the risk free rate is very low given the low interest rate in the banking system in Great Britain (“UK Base Rate”). 2.4 Advantages and disadvantages of equity and debt financing on the part of Tesco Assuming that the company has low retained earnings and is forced to make choices among the three, there is still need to have a balance of the choice of whether to use equity or debt financing as companies need to minimize cost of capital in order to maximize wealth. In choosing between the two or availing from both sources, it is important to see the advantage of each kind of financing. Under equity financing, there is less risk for bankruptcy as there would be less debt to creditors. However, the same could not be maximizing profitability because of non-deductibility of dividends for tax purposes as compared to interest expense when the company avails of debt financing (Brigham and Houston 459). On the other hand, under debt financing, a company can issue bonds, there is benefit of deductibility of interest expense for tax purpose. This would mean higher net income and better cash inflow because of the tax savings. Borrowing which may be done bonds fixes interest expense that would be paid to creditors while allowing the owners to have residual benefit of whatever profits remained after payment of creditors. As the act financing from equity and debt is balancing act, there is need to maintain a targeted capital structure would influence its attainment of minimum cost of capital which would in turn maximize wealth for shareholders. Industries are said to have an ideal capital structure as some are more highly capital intensive or less capital intensive than others. Since asset acquisitions have their own better way to be financed as well depending on the needs of the acquiring company, there is need to understand the industry in order to include in the finance strategy of how to best finance said asset acquisitions without necessarily putting the company as industry player very much riskier than others. 3. Conclusion Section 1 of the paper found good evidence linking the connection between the business model and strategies of Tesco with the objective of shareholders’ wealth maximization. The good financial performance of the company in last five years in terms of profitability, efficiency, liquidity, gearing are supporting investment ratios which tell that the company is building and delivering increase wealth to its shareholders. Section 2 of the paper has found that company is in fact generating very high profitability that is being closed to retained earnings despite giving year dividends to its shareholders regularly for the fast five years. The need to raise £100 million for its new project would not raise much an issue as to which should be the choice of financing that it has actually excessive retained earnings not to be reinvested even an amount of L100 million. As it is the cheapest cost to finance its requirement, then there is no need to issue new share or new debt. Works Cited Brigham, E. and Houston, J. Fundamentals of Financial Management, London: Thomson South-Western. 2002. Print “Financials: Tesco Plc”. 2014. Reuters.com. Web 22 October. 2014 “Annual Report of Tesco 2014”. Tesco.com. Web 22 October. 2014 “UK Base Rate”. 2014. Housepricecrash.co.uk. Web 22 October. 2014 Reuters (2014b). Industry Ratios. Retrieved 17 March 2014 from from < http://www.reuters.com/finance/stocks/financialHighlights?symbol=BT.N Read More