Business Model, Strategies, and Sources of Financing of Tesco - Example

Corporate Finance Introduction Tesco Corporation is an industry whose line of action involves the development and commercialization of the modern drilling technology that ensures increased efficiency and reduced risks incurred while drilling wells. The company was established in the year 1993 and had a large number of employees close to 5000 workers. This paper consists of two sections. Section 1 describes the business model and strategies of Tesco with evidences cited from the case. It explains how the strategy is consistent with the corporate objective of maximizing shareholder wealth. Section 2 assumes that Tesco is about to raise £100M for its new project and considers three financing options: (i) Using retained earnings; (II) Offering ordinary shares to the market and (iii) Offering a ten 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 one strategy and discuss with evidences cited from the case how it is consistent with corporate objective of maximizing shareholder wealth. Tesco’s core business model is retailing to consumers. The key activities in this are to gain customer insight, buying, moving goods and selling to customers. The company tries to improve these functions, supported by its strategies, among others, of building the Tesco Brand, Leveraging Group skill and scale, operating responsively, and establishing a multichannel offer for customers. The financial results measure the company performance while seeking to accomplish its strategies and the objective of wealth maximization. To support its business model, the company also has a number of financial strategies. These include maintaining its good profitability, efficient management of its assets, acceptable liquidity, balanced gearing ratio and responsive investment ratios. The results of the company’s profitability, liquidity, good solvency, and good investment ratios provide good pieces evidence of meeting the financial objectives consistent with the objectives of maximizing wealth of shareholders. This is because when a company establishes a good profitability ratio the trust of lenders and suppliers is one that eventually leads to maximization of profits. Making good strategic judgments has a good way to determining a company’s prosperity and building value for its shareholders over the coming decade. Building shareholder value cannot be done in an instant or short-term. It is a long-term strategy which may even be sacrificing gains in the short-run. 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 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 the industry average of 15.36. A lower P/E ratio in turn leads to higher profits than those prevailing in the market. Although lower than the industry average, this investment ratio is still very high considering the size of the company. These results are acceptable because they are considered to yield profits that are the sole objectives of the business. A return on equity of 14.74% as against the industry average of 10.31 for the past five years. A high return on equity is as a result of high profits. Its efficiency as measured in terms of return on assets for the past five years is also higher at 4.84 as against the industry average of 4.37. In terms of liquidity, the company can still pay maturing obligations with the current ratio of 0.61 as against the industry average of 1.06. Its quick asset ratio at 0.44 is still acceptable as against the industry average of 0.89, considering that it is in the retail industry where cash flows are quick in turnover. Tesco also has good gearing using debt to equity ratio of 0.76 as against the 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 a net advantage in entering into the 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 of paying 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 many 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. 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 ten year bond to the market. Using the current financial market data and your 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 for retained earnings is usually 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 multiplied by the beta as shown in the formula below. Required (or expected) Return = RF Rate + Beta (Market Return - RF Rate) = 0.25% + 0.76 (4.63%-.25%) = 3.58%. Where, the RF rate is given by the annual yield on six month UK gilts (government bonds), and the Market Return is measured by … [FTSE 100?]. The Beta is the beta for Tesco. 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. [SOURCE for Tesco BETA e.g. Google finance or yahoo finance] 2.2 (ii) offering ordinary shares to the market If retained earnings are not retained, they would be distributed to equity holders and therefore should carry the same cost of capital as the return required by new equity holders. In practice, the company may face a slightly higher cost of finance from raising new equity because of the transaction costs of hiring investment banks to prepare and market the sale of new shares in the company. An alternative approach is the use the dividend growth model adjusted for the transactions costs: 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 the growth in dividend, and F for the flotation costs or the charges that would be paid to the 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 the 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 ten 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 company. The marginal tax rate of Tesco was 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? As computed above, the cost of 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 financings from retained earnings and issuance of new share are called equity financing but the former should be preferred as it is cheaper. Another question is whether the company has £100 million available in retained earnings. The profit for 2014 is £970 million and retained earnings have increased from 2013 to 2014 by £807 million. If the dividend pay-out is the same as in the previous year and expected £900 million in profit would just go to retained earnings and not everything will be paid out (“Annual Report of Tesco 2014”). Thus since the cost of financing the £100million is cheaper from retained earnings, which are available, there is no need to issue new share. 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 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 a benefit of deductibility of interest expense for tax purpose. This would mean higher net income and better cash inflow because of the tax savings, but would also raise the risk of the equity. Borrowing has the advantage of fixed interest expense (which is easier to predict) and as long as the company is profitable well above the amount required to cover the interest and debt repayments, the owners will have a leveraged residual benefit of whatever profits remained after payment of creditors. As the act financing from equity and debt is balancing act, there is a need to maintain an optimal capital structure which is the level of gearing that minimizes the 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 and the business cash flow varies across industries and sectors. Some asset acquisitions also attract tax benefits or subsidies and could be influenced by the cash flow needs of the acquiring company. So it is important also to understand the industry and the context of the financing decisions. 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. Tesco has in the last five years faced financial irregularities that lead to investigation on fraud, some of these issues are said to have been caused by high completion from retailers. It has also emerged that the problem may have been going on for longer than first believed, spanning years and not months. The financial performance of the company in terms of profitability, efficiency, liquidity, gearing support investment ratios have been declining which tells that the company has failed to increase the wealth of its shareholders. The chief executive has just initiated a strategic review which will focus on reducing costs, strengthening the balance sheet, restoring trust in the brand and dropping the overall prices. Section 2 of the paper has found that the company can generating strong profitability and retained earnings despite giving annual dividends to its shareholders regularly. A rights issue is not on the cards despite this has not been ruled out yet; a cheaper source of fund is thus recommended in order to reduce the overall prices of the services. The need to raise £100 million for its new project would be possible from retained earnings as it is the cheapest cost to finance its requirement, and there is no need to issue new share or new debt. This will ensure a lower expenses budget. 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 < http://www.reuters.com/finance/stocks/financialHighlights?symbol=BT.N Read More