Financial Management Performance of Walmart - Essay Example

FINANCIAL MANAGEMENT ANALYSIS Table of Contents Introduction 3 Walmart Stores Inc 4 Financial performance of Walmart 4 External sources of finance available to Walmart 5 Consideration for selecting type of finance 8 Calculation of WACC 10 About WACC 10 Information about the WACC of Walmart 11 Problems and difficulties encountered by Walmart for choosing capital structure 13 Conclusion 14 Recommendations on the capital structure and WACC of Walmart 14 Reference list 15 Bibliography 16 Introduction According to Bierman (2003) capital structure of a company is defined as the mixture of debt and equity capital. Capital structure of a business firm can affect the value of the firm through its impact either on the expected income or the cost of capital or both of the concerned business firm. The capital structure decision affects the earnings available to the shareholders and also affects the value of the firm. There are two primary source of raising capital, which are discussed henceforth along with weighted average cost of capital. Debt capital is the capital which is raised by the company through taking loans. The loan taken by the company is paid back at some future specified date. The interest at which the debt financing is done is called the cost of debt Emmanuel (2012). In debt financing full ownership is retained by the company but the company has to repay the sum due on bonds issued or loan taken before repaying the equity investors. A company with high debt-equity ratio means a company which is highly leveraged or highly reared. According to Chandra (2011) the debt-equity ratio or leverage of a business firm influences the cost of capital and simultaneously the value of the firm. In order to form the desired capital structure a business should be based on minimum cost of capital and maximum value possible of the firm. The portion of capital which is raised by sale of shares or stock is known as equity capital. This capital is owned by the shareholders and involves certain level of shareholders expectation on the investment made. In order to retain the shareholder investment it is very important to ensure return in the form of dividend and appreciation in share price. According to Wiley (2007) the risk of the shareholders is comparatively more than the debt-holders; however, in equity financing a distribution in ownership takes place. A company has two primary sources to raise its capital: debt and equity. According to Graham (2012) to measure the cost of capital of a firm, WACC technique is used. This technique allows the company to determine the accurate cost of financing of any project by allocating suitable weightage to the different sources of finance available . Walmart Stores Inc Walmart Stores Inc. is one of the old and renowned names in the retail industry that has been serving the nation with different retail structures like cash and carry stores, supercenters, apparel stores, bodegas, small discount stores, food and drugs, general merchandise stores and restaurants. The company is committed to serve the diverse choice of the Americans with unique quality, value and style. At Walmart customers enjoy the privilege to choose from a variety of national, exclusive and private brands (Walmart Stores, Inc, 2015a). Financial performance of Walmart The analysis of the financial statement of Walmart over a period of three years reveals that the company’s total Shareholder’s Equity and the long-term debt position has increased over the years. The Debt-Equity ratio of Walmart over a period of three years from 2012-2014 are 1.64, 1.58 and 1.59 respectively whereas the standard debt-equity ratio of retail industry is 0.73 (Walmart Stores, Inc, 2015b). This shows that Walmart is employing higher amount of debt capital in the capital structure of the company. The long-term debt of Walmart includes non-convertible debt, convertible debt, long-term debt excluding capitalized leases and capitalized lease obligations. Debt is considered to be a relatively cheaper form of finance than equity because it can be obtained at a lower effective cost if the company is performing well and the rate of interest which is payable on debt is fixed as well as lower than the interest rate of dividend paid on shares (Walmart Stores, Inc, 2015b). External sources of finance available to Walmart Short-term borrowings: The short-term borrowings comprises of any debt which is due within one year and generally comprises of the short-term bank loans taken by the company. From the annual report of Walmart it is inferred that the short-term borrowings of the company has increased from $6805M in 2013 to $7670M in 2014 but again fallen in 2015 to $1592M. This shows that the company was engaged in taking more short-term borrowings till 2014 but they chose to repay the debt on short-term borrowings in 2015 (Walmart Stores, Inc, 2015b). Long-term debt due within one year: These are very short-term debts appearing in the balance sheet of the company. It represents the current portion of long-term debt where the payment becomes due within one year. It helps to analyse the solvency position of the company. From the balance sheet of Walmart it is inferred that the long-term debt position of the company which is due within one year was reduced to $4103m in 2014 compared to $5587 in 2013 but in 2015 the company engaged themselves in a higher amount of long-term debt due within one year to the tune of $4810M (Walmart Stores, Inc, 2015b). If the debt position is compared with the cash and cash equivalents of Walmart it can be concluded that with the decrease in short-term debt position, the cash position has also decreased from $7781m in 2013 to $7281m in 2014 which shows the company makes quick payments of the long-term debt due within one year, however in 2015 the company did not pay back more of its long-term debt due within one year as the cash and cash equivalent position shows a considerable increase in the balance sheet (Walmart Stores, Inc, 2015b). Capital lease obligations due within one year: This represents the amount at the commencement of the lease term which is equal to the principal amount or the present value of the least number of lease payments during the term of the lease which excludes the executory costs like insurance, taxes to be paid by the lessor and maintenance charges (Stock Analysis on Net, 2015). From the balance sheet of Walmart it is recorded that the position of capital lease obligation due within one year has decreased from $327M in 2013 to $309M in 2014 and to $287M in 2015 respectively which indicates a favourable position for the company (Walmart Stores, Inc, 2015b). Long-term debt exceeding one year: Long-term debt obligations exceeding one year refers to the medium-term and long-term financial needs of the firm. This includes loans, mortgages and bonds that are to be paid over a period exceeding one year. It is noted from the annual report of Walmart that the company’s long-term debt includes both secured and unsecured debts. From the balance sheet of Walmart it is recorded that the position of long-term debt has increased in 2014 to $41771M from $38394M in 2013 but reduced to $41086M in 2015 whereas the equity position of common stock has decreased to $323M from $332M and remained constant in 2015 which indicates that the company is using more of debt financing to expand its business (Walmart Stores, Inc, 2015b). The long-term debt to capitalization ratio of the company is maintained at 0.99. If the ratio is greater than 1, it indicates that the business has higher amount of debts than capital, this is not good for the company as it leads to financial distress. In this case Walmart needs to control their long-term debt to capitalization ratio so that it does not exceed 1 (Walmart Stores, Inc, 2015b). Long-term capital lease obligations: This is generally a non-cancellable lease obligation which covers almost the entire economic life of the asset. It transfers considerably all the risks and rewards of ownership of an asset. The selection of lease arrangement will have significant impact on the financial statements. The balance sheet of Walmart shows that there is a decrease in the long-term obligations under capital lease to$2606M in 2015 and $2788M in 2014 from $3023m in 2013 which indicates the company has been reducing their long-term capital lease obligations (Walmart Stores, Inc, 2015b). Common Stock: The fund invested in equity is called common stock and it represents ownership position in a company. Common stock comes with the following features: the shareholders have a residual claim on the income and the assets of the company, they also have the right to control the operations of the company, the right to vote and pre-emptive right. The fundamental income per equity share from regular operations attributable to Walmart is based on the weighted-average of equity shares outstanding during the related period. Diluted income per equity share from regular operations attributable to Walmart is based on the weighted-average of equity shares outstanding during the related period adjusted for the dilutive effect of outstanding stock options and other share-based awards. From the balance sheet of Walmart it is noted that there has been a decrease in the common stock for the year 2014 to an amount of $323m from $332m in 2013 and the company did not issue any fresh stock in 2015 (Walmart Stores, Inc, 2015b). This can be attributed to the repurchase of shares of its common stock under share repurchase programs authorized by the Board of Directors. The Company considers numerous factors like capacity for leverage, current cash needs, cost of borrowings and the market price of its common stock while determining the execution of share repurchases (Walmart Stores, Inc, 2015b). Retained Earnings: Reinvesting a part of the profits or ploughing back the profits is a perfect method of financing expansions or development. Many factors influence the practice of ploughing back of profits, such as: dividend policy, taxation policy, statutory requirement, desires of the shareholders, net profit and attitude of the management and requirements of the company in future. From the balance sheet of Walmart it is noted that there has been an increase in the retained earnings of the company to both in 2015 and 2014 to the tune of $85777M and $76566M respectively from $72978M in 2013 which indicates the company has not paid sufficient dividend, but reserved the earnings either to pay the debts or to reinvest it in its core business (Walmart Stores, Inc, 2015b). Consideration for selecting type of finance The balance sheet of Walmart shows that the company has raised its capital through two external sources of finance: debt and equity. While choosing the type of finance the company could have taken into consideration the role of trading on equity. Trading on equity is a financial tool available to the management through which the non-equity source of funds are utilised to provide a high rate of return to the equity shareholders. By employing trading on equity the shareholders are given a compensation for bearing the risk. If the management wants to raise a paid-up capital of $5000000, the available sources of finance are: equity, debt and preferred stock. Suppose the management chooses to raise the entire amount through equity shares and the company earns a profit of $500000 which is 10% on the total capital then the company will not be able to pay anything more than 10% or more than $500000 as dividend to the common stock holders. In this case the company can adopt the following capital structure: Components Amount i. By issuing 6% debt $2500000 ii. By issuing 8% preference shares $1000000 iii. By issuing equity shares $1500000 Total $5000000 In this case the company forms the capital structure by issuing funds to the tune of $3500000 through a fixed rate of interest and dividend from debt and preference shares respectively. According to Bierman (2003) preference shares are those stocks that guarantees specific dividend and this security is preferred over equity stock. The company will have to pay $150000 which is 6% of $2500000 as interest on debt and $80000 which is 8% of $1000000 as dividend on preference shares. The remaining balance of $270000 which is $500000 – ($150000+$80000) will be the residual income available for paying dividend to the equity shareholders. New equity capital is $1500000 and the new return on equity in the form of equity dividend will be 18% (i.e. $270000/$1500000 x 100). By increasing the proportion of fixed interest and dividend bearing securities in the capital structure, the company’s rate of dividend available for the equity shareholders gets considerably increased to 18% from 10%. This happens due to the practice of trade on equity by the company while planning its capital structure. An added advantage to this concept is the availability of tax deductibility of interest on such borrowed capital. It is a blessing when the company’s earnings are increasing, however it can lead to a situation of financial distress and insolvency if the company’s earnings are not sufficient to meet the debt obligations. The balance sheet of Walmart shows that the company has not employed any preferred stock in their capital structure and the amount of debt is also not very high. The company possesses a higher amount of retained earnings which can be employed to arrange the fixed interest bearing securities and implement the concept of trading on equity. Calculation of WACC About WACC As the name implies, the weighted average cost of capital (WACC) is the weighted average of the costs of several components of the capital structure of a company. According to the proportion of the components in the capital structure the different weights are assigned which helps in calculation of the WACC. WACC is calculated by assigning weights to the required rate of return of equity and the interest bearing securities to the approximate percentage in the capital structure Risius (2007): WACC = (RE X we%) + ( RD x wd%) WACC = Weighted average cost of capital RE = required rate of return on equity after tax We % = weight or percentage of equity in the total capital invested RD = required rate of return on debt after tax Wd% = weight or percentage of debt in the total capital invested Information about the WACC of Walmart For the calculation of the WACC of Walmart the following information is required (Walmart Stores, Inc, 2015b): Fair Value of Equity Fair Value of Debt Fair Value of Obligations under capital leases due within one year Required rate of return on equity estimated using CAPM Required rate of return on debt Required rate of return on debt after tax Effective (average) income tax rate No. of Shares of common stock outstanding Current price of the shares Computation of WACC (Walmart Stores, Inc. 2015b) Calculation of WACC of Walmart   Component Value Weight Required rate of return Weighted cost Long-term and Short-term debt and capital lease obligations (fair value) 60722 0.21 2.80% 0.00588 Common stock or Equity (fair value) 234907 0.79 7.33% 0.057907 WACC       0.063787 WACC of Walmart is 6.40%. The following information is considered for calculating the WACC of Walmart: 1. Common stock or equity (fair value) = Current price of common stock x no. of shares outstanding in common stock 2. Required rate of return on equity is estimated by using CAPM (Stock Analysis on Net, 2015b) 3. Required rate of return on debt after tax (Stock Analysis on Net, 2015c) = 4.15% x (1 – 32.46%) 4. Effective (average) income tax rate = ( 32.20% + 32.90% + 31% + 32.60% + 32.20% + 32.40%)/6 = 32.46% 5. Fair Value of total debt US$ in millions Jan 31, 2015 Long-term debt including amount due within one year 56237 Short-term borrowings 1592 Obligations under capital leases 2893 Fair value of total debt and obligations under capital leases 60722 Ratio: fair value of debt to carrying amount 1.21 The WACC of Walmart is 6.40% which is less than the industry benchmark which is 6.76% (Damodaran, A. 2015). The company can optimize its capital structure to the extent of industry benchmark as its debt-equity ratio is also less than 1. Problems and difficulties encountered by Walmart for choosing capital structure The annual report of Walmart shows that the company’s EPS growth rate has fallen to 19% in 2015 when compared with the EPS growth rate of 30% in 2014. Similarly, the return to the common stockholders or the shareholders fell to $64B in 2015 which was $68B in 2014. This fall in the financials of Walmart is attributed to the fall in overall consolidated growth in net sales in 2015. The consolidated growth in net sales in 2015 came down to $64B which was n$68B in 2014. The decrease in the consolidated net sales is attributed to the limited expansion scope taken up by the company. From the balance sheet of Walmart it is inferred that the company’s high retained earnings were not reinvested in business or used for modifying the capital structure. The company did not issue any fresh equity shares which shows the company did not wish to expand its capital structure (Walmart Stores, Inc, 2015k). Conclusion The WACC of Walmart is 6.40% which is less than the WACC of the general retail industry. The WACC of the general retail industry is 6.76% which indicates that the company has the scope of expanding its capital structure base. The debt-equity mix of Walmart is also less than 1 which portrays a favourable position, but the company holds large amount of funds as retained earnings. Since the company is not reinvesting its retained earnings in the business, the capital structure is not being optimized. Recommendations on the capital structure and WACC of Walmart 1. The balance sheet of Walmart shows that the company uses only two external sources of finance in the form of debt and equity. The management should take into consideration the introduction of preferred stock in the capital structure. 2. The management of Walmart should implement the concept of trading on equity and introduce more amount of fixed interest bearing securities in the capital structure in the form of debentures and preference shares. 3. The company should utilize the internal source of finance in the form of retained earnings to expand its capital structure. 4. The company has a scope of expanding its WACC as it is comparatively less than the industry benchmark but it should not exceed the benchmark as minimum cost of capital is always desirable. Reference list Bierman, H., 2003. The capital structure decision. New York: Kluwer Academic Publishers. Chandra, P., 2011. Financial Management. New Delhi: Tata McGraw Hill Education Private Limited. Damodaran, A. 2015. Cost of Capital by Sector (US). [online] Available at: < http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/wacc.htm> [Accessed 11 June 2015]. Emmanuel, M., 2012. Basics of Business and Management. New Delhi: Dorling Kindersley (India) Pvt. Ltd. Graham, J., Smart, S., 2012. Introduction to Corporate Finance. Mason: Centrage Learning. Risius, J., 2007. Business valuation: A primer for the legal profession. Chicago: ABS Publications. Stock Analysis on Net, 2015a. Capital Lease Obligations, Current. [online] Available at: < https://www.stock-analysis-on.net/NYSE/Company/Walmart-Stores-Inc#Financial-Statements> [Accessed 11 June 2015]. Stock Analysis on Net, 2015b. Expected Rate of Return. [online] Available at: [Accessed 11 June 2015]. Stock Analysis on Net, 2015c. Weighted-average Interest Rate on Debt. [online] Available at: < https://www.stock-analysis-on.net/NYSE/Company/Walmart-Stores-Inc/Analysis/Debt#Weighted-average-Interest-Rate-on-Debt> [Accessed 11 June 2015]. Stowe, J., 2007. Equity Asset Valuation. New Jersey: John Wiley and Sons, Inc. Walmart Stores, Inc, 2015a. History. [online] Available at: < http://corporate.walmart.com/our-story/history/> [Accessed 11 June 2015]. 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