Asda: The Company's Capital Structure Starting from 2008 - Essay Example

COLLEGE/UNI ASDA – Capital Structure Asda-the companys capital structure starting from 2008 Each and every company or organization requires a proper mix of finance to operate the organization in a smooth manner. Capital structure refers to the way in which a company is financed by a mix of long term capital such as ordinary share capital, reserves, debentures, etc and short term financing such as bank overdraft. Companies use different financing decisions based upon the investment opportunities and the company’s current capital structure. Each sort of financing has its implications. Debt financing is deemed to be less risky for the debt holder as it includes interest and it can be secured. The cost of debt to a company is therefore relatively less than equity financing. Besides this, debt is considered cheaper by the providers of finance and it attracts tax relief on interest payments. The greater the level of debt, the more will be the financial risk to the shareholder of the company. Hence the return required would be higher. This also helps in establishing the gearing mix of a company. The higher a company is geared, the higher would be the risk involved. There are many factors that contribute towards the availability of different sources of funds {(Goyal et al (2005); Darren (2006)}. Equity financing is raised by issuing equity shares or rights issue, preference shares issued are not considered as equity issue as they carry a fixed percentage that is to be paid to the preference shareholders and hence in substance preference shares have a debt nature attached to them so they are categorized under debt issue. Equity finance is considered a comparatively more risky approach of raising finance than debt financing, it is also considered more costly to raise equity finance than to raise debt finance (Burton et al, 2003). Asda is a UK based supermarket chain which deals in clothing, grocery, children toys and other general products used during normal routine. It is a subsidiary of the American Wal-Mart. Asda initiated its business involving Dairy products and later went on to diversify its business. It has been always renowned for its great marketing strategies. It was taken over by Wal-Mart as a subsidiary in 1999. Asda is considered as the second largest retail chain business after TESCO in the United Kingdom. Later in 2009, Wal-Mart made a deal to sell Asda to Corinth Services Limited for an amount of £6.9 million. Since that deal Asda is a subsidiary of Corinth Services Limited (Telegraph.co.uk, 2010). Gearing is one major issue which has a critical effect onto the capital structure of a company. The higher a company is geared, the more difficult it would be for the company to raise debt finance as the institution giving out the debt would be exposed to greater risk. One view is that there is an optimal capital mix at which the average cost of capital, weighting according to the different forms of capital employed, is minimized. As gearing increases, the return expected by ordinary shareholders begin to rise in order to compensate them for the risk resulting from a larger share of profits going to the providers of debt. Certain ratios need to be calculated to ascertain the capital structure of Asda Financial Gearing = Capital raised through Debt/Prior Charge Capital ÷ Shareholders Funds * 100% Debt/Equity Ratio = Total debt ÷ Total Assets Interest Cover = Profit before Interest and Tax ÷ Interest Prior Charge Capital for Asda (Year 2008) = 292,723 Gearing Ratios for Asda according to the figures in the Balance Sheet Description Calculation Year 2008 Financial Gearing 292,723 ÷ 2,759,588 * 100 10.6% Interest Cover 594,932 ÷ 60 9915 times Debt/Equity Ratio 292,723 ÷ 7,544,646 3.9% The ratios calculated above clearly indicate that Asda is primarily financed through equity; the option of availing debt finance is minutely used by the company. The gearing ratio clearly suggests that the company is way too much dependent upon equity financing. Interest cover on the other hand is a measure of financial risk which is designed to show the risks in terms of profit rather than in terms of capital values. Asda has a distinct ability and a proper platform to draw debt finance so as to cover up the negative working capital amount that it has to face in the year 2008, if no funds are taken up to finance the shortfalls in the daily operations of the company, the company may face bankruptcy. Asda can opt for debt finance as their gearing position seems pretty favorable for the company to get proper investors who can lend the company. An optimum capital structure is to have a balance between the debt financing and the equity financing to ensure that the company embarks and meets its long term objectives. Factoring is a method used by companies to smoothen the working capital position of the company. Factoring is usually an arrangement to have outstanding debts collected by some other company i.e. the factor company, the factor company in return advances a proportion of the underlying debt which is due to be collected in advance. Both companies enjoy the benefit as the factor company receives its commission along with its cut of the debt and the company getting the factor services gets their required money in advance to pay off any particular short term obligations. Asda cannot use up the factoring services as they do not have too much cash stuck up in their debtors, on the contrary, they have a huge amount of short term dues and obligation which really dent their working capital position. Asda has gathered short term funds to finance its activities, this can be really harmful for the operations of the company as these short term obligations need to be paid out within a short notice period, the company has gathered short term finance from different creditor and other institutions such as banks, their current liabilities clearly reflect a bank overdraft. Asda, besides using creditor and banks, have taken up loan/funds from its group. Inter group loans are cheap way of obtaining finance for any company within a group, although such loans are not shown in the Consolidated Statement of Financial Statements. Capital markets and the Money markets are markets for long-term and short term capital respectively, a stock market acts as a primary market for raising finance and it acts as a secondary market when it comes to trading existing securities e.g. stocks, shares, etc. Capital markets help in attaining long term capital in contrast to Money market which lend on a shirt term basis. Capital markets deal in long term financing and instruments such as equity, debentures, etc. Stock markets are a good example of Capital markets. In an efficient market, the share prices reflect the type of information available to the investors. Hence an efficient capital market is one in which the prices of securities bought and sold reflect all the relevant information which is available to the buyers and sellers, in such markets share prices change quickly to reflect all new information about future prospects. No individual can dominate in such market. Share prices would vary in a balanced manner if a stock market is efficient, if a company makes a profitable investment, shareholders will know of it and would behave accordingly leading to an increase in the market price of the company’s shares in anticipation of future dividend increase and vice versa, hence an efficient market is one in which the market prices of all the securities traded on it reflect all available information. In such a market, there would be no possibility of forcing the share price to increase or to decrease to unrealistically high or low levels by speculative pressure. This in return would increase the confidence of investors, assuring them that the prices that they pay for shares and debentures give a proper reflection of their correct value. Portfolio theory suggests that different products or services should be chosen to lower the risk. If a diversified portfolio of products is chosen it can lower the risk in totality i.e. if more than one product is chosen and any one of them is not that much profitable or is loss making, its loss would be adjusted by other profit making profits hence when adding up all these products together would be to have a portfolio of diversified products, Asda uses a portfolio theory as it carries out such a diversified line of operations, its vast line of products can help to overcome the loss of any one particular loss making product. Asda has many Private labeled brands, although the products may be the same, the brand name used for them may be different. “Asda’s own label portfolio is impressive. Asda private label has a 45 percent share in grocery and a 50 percent share in non-food in relation to its total store sales, according to retail analysts M&M Planet Retail” (Stephen Foster, 2004). Asda’s Balance Sheet for the Year 2008 clearly suggests that the company is overtrading. Overtrading usually happens when a business tries to do too much quickly with too little long term capital in hand. There are many signs and symptoms that can be seen and can be calculated with the help of the financial statements to illustrate that the company is overtrading. The huge and the most impactful sign of Asda overtrading is the fact that the company’s has an excess of current liabilities over its current assets. Besides this factor, the other factor that indicates that overtrading is taking place within Asda is the fact that the company’s trade creditors are also increasing. To avoid the risk of bankruptcy, Asda should try to inject new capital along with better control of creditors, stock and debtors. Except all the above issues, the management of Asda should keep a clear understanding and calculation of the time value of money when deciding upon any new investment project. The time value of money is an important aspect when appraising any new project. Such time value of money is usually used to Discount cash flows. “A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced payments or receipts promised in the future can be converted to an equivalent value today. Conversely, you can determine the value to which a single sum or a series of future payments will grow to at some future date.” (Get Objects, 2002) Time Value of money is the mere concept that any denomination of a currency may not be holding the same value after a specified period of time as compared to the value that it holds today. Systematic Risk is the risk that the financial system might just crumble under circumstances that are considered to be outside the control of an investor (usually macro-economic factors). To appraise a project, an appropriate discount rate should be taken, the risk faced by the investor needs to be taken into consideration. The total risk of a portfolio (measured by means of standard deviation of returns) consists of two types of risk: unsystematic risk and systematic risk. Investors having a large number of portfolios can reduce or may eliminate the unsystematic risk, but the systematic risk cannot be eliminated and it remains. Hence Total Risk = Systematic Risk + Unsystematic Risk. Systematic risk reflects market wide or macro-economic factors for e.g. Corporate Tax Rates, Interest Rates, Level of Inflation, etc. As all these factors cause the returns to follow in the same trend, they cannot cancel out. Systematic risk of an investment is calculated by the coalition of an investment’s return with the returns of the market. After calculating the systematic risk it is divided by the market risk to calculate a relative measure of systematic risk and this is known as the BETA and is denoted by the symbol β. A project beta is usually found by identifying a quoted company with a similar business risk profile as the project and hence that particular beta is used, however when selecting an appropriate beta of similar company care must be taken with respect to the different gearing ratios in both the companies. The beta values for companies reflect the business risk (risk resulting from operations) and finance risk (risk as a result form the different level of gearing). The Capital Asset Pricing Model (CAPM) provides the required return based on the perceived level of systematic risk of an investment. R = Rr + (Ru – Rr)*β R = required rate on shares in a company Rr = risk-free rate of return – normally based on the return on treasury or other government bills. Ru = average return on the market, normally based on the return on Stock Exchange (Ru – Rr) = market risk premium – this is the reward that investors receive over and above the risk-free rate for investing in shares that have the same level of risk as the market. β = beta of shares – this measures the systematic risk of the shares in a company relative to the systematic risk on the market i.e. market risk. The alternate formula to calculate Capital Asset Pricing Model (CAPM) is Required Return = Rf + βi (E(Rm) – Rf) where: Rf = the risk free rate, usually on treasury bills E(Rm) = expected return on the market. βi = project beta = systematic risk of the investment compared to the market. The CAPM asserts that share move in line with the market. If the market moves a 1% and the share ahs a beta of two, then the return on the share would move by 2%. Different beta values give different ideas about different sort of shares as such: Beta>1 – Aggressive shares: These shares tend to go up faster than the market in a rising (bull) market and fall more than market in a declining (bear) market Beta Read More