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Critical Analysis Of The Financing Policies of Tesco plc

Hausarbeit (Hauptseminar) 2015 21 Seiten

BWL - Investition und Finanzierung

Leseprobe

Table of Content

List of Abbreviations

List of Charts

List of Diagrams

List of Tables

1. Critical Discussion of Tesco’s Objectives
1.1 Primary Objective
1.2 Secondary Objectives

2. Gearing Policy
2.1 Development of Gearing
2.2 Impact on Financial Figures

3. Dividend Policy
3.1 Literature review
3.2 Analysis of Tesco

4. Capital Structure Policy
4.1 Pecking Order Theory
4.2 Trade-Off Theory

5. Appendices

6. References

List of Abbreviations

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List of Charts

Graph 1:Share Price Development in Pence

List of Diagrams

Diagram 1:Turnover Development in GBP

Diagram 2:COGS, trade creditors and CPP in GBP / days

Diagram 3:Liability- / Equity- / Gearing-Development

Diagram 4:Development of Equity Structure

Diagram 5:Decision Process Pecking Order Theory

Diagram 6:Trade Off Theory

Diagram 7:Interest Coverage

Diagram 8:Earnings per Share in pence

Diagram 9:Adj. P/E Ratio

Diagram 10:Correlation Interest Coverage - Net Gearing

Diagram 11:Correlation EPS - Net Gearing

Diagram 12:Correlation P/E-Ratio - Net Gearing

List of Tables

Table 1:Dividends Paid in GBP and Return on Shareholder Funds

Table 2:Financial Figures

Table 3:Dividend Analysis

Table 4:Interest Paid

1. Critical Discussion of Tesco’s Objectives

1.1 Primary Objective

Tesco plc, headquartered in England, is a leading grocery retailer in Great Britain. Operating stores in 12 countries across Europe and Asia, the company focuses on six corporate objectives in order to run its business successfully. In the following the primary and two selected secondary objectives of Tesco are critically discussed (Tesco, 2015a).

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Graph 1: Share-Price-Development in Pence (Own illustration based on Tesco, 2015b)

The primary objective of Tesco is maximizing shareholder satisfaction (Tesco, 2015a). This aspect is measured by the development of dividends and share prices. Tesco’s share price in the financial year end of 2010 (28th February) was GBP 419.8 and declined to GBP 166.2 until the half-year end in 2015 (28th September). As demonstrated in graph 1, the shareholders, suffering a total loss of 60.41%, have not been satisfied concerning the share price development since 2010.

The dividends paid by Tesco, by contrast, have been growing approx. 22.8% over a four year period from 2010 and provided the shareholders with progressive returns on their investment (table 1, page 2). Nevertheless, in 2015 the dividends strongly declined and even dropped below the level of 2010. The third factor indicating that Tesco did not achieve its primary objectives are the ROSF, which decreased strongly from 15.35% (2014) to -90.17% (2015).

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Table 1: Dividends Paid in GBP and Return on Shareholder Funds (Own illustration based on FAME, 2015)

As a result, it could be said that Tesco did not meet its primary objective to satisfy its shareholders within the presented period.

1.2 Secondary Objectives

Moreover, Tesco states to “offer customers the best value for money and the most competitive prices“(Tesco, 2015). Nevertheless, in order to critically evaluate the customer satisfaction it’s necessary to have a closer look at the revenue development of the company. From 2010-2013 the revenue increased year-by-year (diagram 1), but declined slightly in the past two years. It could be said that Tesco managed to uphold a good customer satisfaction until 2013 which then started dropping. This development is also underlined by recent customer surveys in 2014 which show that Tesco is ranked behind all of its rivals in terms of price, range, service, quality, etc. (Ruddick, 2015).

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Diagram 1: Turnover-Development in GBP (Own illustration based on FAME, 2015)

Furthermore Tesco sets the target to “(work) closely with suppliers to build long term business relationships based on strict quality and price criteria” (Tesco, 2015a). In order to evaluate the supplier satisfaction, different figures should be considered. On the one hand, the cost of sales should go up, on the other hand, the creditor payment period is supposed to be stable and the development of trade creditors should be assessed. Tesco paid its suppliers in reasonable time and even managed to lower its creditor payment period (diagram 2), which is an advantage for the supplier who receive their payments earlier. However, the trade creditors increased steadily until 2014, but fell back to the level of 2010 in 2015. This reduction of the credit line provided by the suppliers could indicate a decline in supplier satisfaction. Whereas the COGS have increased steadily in the past five years which indicates a higher turnover for the suppliers. Therefore, it could be said that Tesco broadly meets the objective to satisfy its suppliers.

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Diagram 2: COGS, trade creditors and CPP in GBP / days (Own illustration based on FAME, 2015)

In a nutshell, it could be said that Tesco did not meet the set objectives in the last five years. The company could not maximise shareholder satisfaction and although it could manage to achieve supplier satisfaction, the customers seem to be not satisfied within the last year. This goes hand in hand with the accounting fraud Tesco committed in 2014 by overstating its profits about GBPm 250 (Ring and Chambers, 2015) and should be considered by (potential) investors.

2. Gearing Policy

2.1 Development of Gearing

This chapter aims to analyse the gearing development of Tesco within the last five years and to explain the reasons for the perceived changes in gearing

Analysing the gearing development of Tesco in the last five year it can clearly be stated that the gearing is increasing year by year with a significant change from 2014 to 2015 (diagram 3). As a result, Tesco had to pay a higher amount of interest year-by-year (table 4, appendices). One reason for a high gearing could be the accumulation of debt by a company in order to undertake growth- or expansion investments. In the case of Tesco, there are two reasons for the high increase. While on the one hand, the amount of liabilities is steadily increasing year by year, on the other hand shareholder funds decrease by more than 50% from 2014 to 2015.

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Diagram 3: Liability- /Equity-/Gearing-Development (Own illustration based on Fame, 2015)

A closer look at Tesco’s equity structure shows, that the enormous change from 2014 to 2015 is mainly due to a reduction of the company’s reserves, more specifically the profit(loss) account. This development in presented in diagram four(page 5). Since Tesco had a retained loss of GBPm -0.2 in 2014 and GBPm -6.6 the equity decreased significantly.

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Diagram 4: Development of Equity-Structure (Own illustration based on Fame, 2015)

2.2 Impact on Financial Figures

Moreover, there is a significant impact on certain key financial figures by a company’s gearing, which is discussed in this subsection.

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Table 2: Financial Figures (Own illustration based on Thomsett, 2006, p. 182-186)

Firstly, Tesco’s interest coverage is affected. Stating the company’s ability to fulfil its financial obligations, according to the formula presented in table 2 the figure should show a number > 1. Tesco’s interest cover is decreasing within the presented period. The reason for this development could be seen in the significantly increasing amount of interest due to the increasing gearing as shown in diagrams 7+10 (appendices).

In addition, EPS is a key figure to assess a company’s profitability (table 2). As demonstrated in diagrams 8+11 (appendices), the company’s EPS are decreasing as the gearing is increasing. A possible explanation could be found in the declining earnings development due to more debt.

At last, the P/E-ratio (table 2) is a key measure to assess a company’s share price. As Tesco’s gearing is increasing significantly from 2014 to 2015, the P/E-ratio of Tesco is dropping (diagram 9+12, appendices). A possible reason could be seen in the negative effect on earnings due to a higher debt obligation.

3. Dividend Policy

3.1 Literature review

In literature, dividend policies are subdivided in three predominant theories according to their effect on shareholders wealth:

1. no effect: irrelevance theory of Modigliani and Miller (1961) [MM],
2. increase: bird-in-the-hand theory [BHT],
3. decrease: tax-preference theory [TPT],

which are reviewed in the following section.

The theory of M&M is based on the assumption of rational investors and a perfect capital market. Hence, it is irrelevant to investors, if a company pays dividends or retains the earnings. (Lumby and Jones, 2003, p. 534-548; Allen and Michaely, 2003, p. 339). The company value is dependent of future cash flows. Although the theory has been review by further academics and is valid until today (Bernstein, 1996; Miller and Scholes, 1978), it has sharp limitations (Ball et al., 1979). By applying those theories, it has to be taken into consideration that M&M assumptions of a perfect capital market are not realistic. There are information asymmetries (principal-agent theory), tax influences, incomplete contracting possibilities and trading costs which indeed influence companies (Baker and Gary E. P., 1999). Therefore, criteria have to be relaxed in order to conduct empirical studies (Al-Malkawi et al., 2010).

The BHT provides an alternative approach, arguing that the company value is indeed affected, increasing, through dividend payouts. Due to uncertainty about future development, dividends are preferred to future cash flows (Al-Malkawi et al., 2010). Although this theory found support of e.g. Lintner (1962) or Gordon and Shapiro (1956), it is criticised to overweight the company’s risk, which is a rather strategic issues (Bhattacharya, 1979), to not provide sufficient explanation for dividend payments (Baker et al., 2002) and there is very little empirical data supporting this theory.

The TPT, in contrast to the BHT, assumes that lower dividend payments increase a company’s value. Considering tax, this theory argues that dividends underlie a higher tax duty than capital gains and therefore companies that retain earnings are preferred by investors (Litzenberger and Ramaswamy K., 1979 ; Brennan, 1974).

3.2 Analysis of Tesco

In a next step, the theories are applied to Tesco. Since the company pays two dividends a year, the following table focusses on the prelim payment, which is the higher one.

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Table 3: Dividend-Analysis (Own illustration based on (Yahoo Finance, 2015)

Since there is no dividend paid in 2015, the table lists the payments from 2010-2014. By calculating the value for the shareholder, it could be argued for both, the BHT and the TPT theory. Whereas in 2010 and 2014 the value is negative (TPT), from 2011-2013 the value is positive and therefore the BHT is valid.

As a result, it could be said that dividends can indeed affect shareholders wealth, in a positive as well as in a negative way. Therefore, M&M theory can be rejected for Tesco.

4. Capital Structure Policy

4.1 Pecking Order Theory

The choice of the most adequate capital structure to maximise the firms value is an issue for more than 50 years (Mogdiliani and Miller, 1958). Nevertheless, the two capital theories which are presented in this chapter have always been predominant in the capital structure decisions of companies (Jahanzeb et al., 2014).

The base of the pecking order theory was set by Donaldson (Baker and Martin, 2011) who dealt with corporate debt capacity in 1961 (Donaldson and Fox, 2000). According to the pecking order theory no target debt-to-equity ratio is defined, but internal financing is strongly preferred and a company’s priories their sources of financing as demonstrated in the diagram below (Lumby and Jones, 2003, p 442-502).

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Diagram 5: Decision-Process Pecking-Order-Theory (Own illustration)

Later on further studies have been conducted in order to explain companies behaviour in corporate finance and their tendency to rely on internal sources of funds and could prove that debt to equity is preferred if external financing is required (Myers, 1986; Myers and Majluf, 1984).

There are some empirical studies, e.g. in the UK and Australia, which underline the negative relation between profitability and corporate debt option (Allen, 1993; Collins et al., 2013; Strong, 1998) and therefore the pecking order theory. Moreover, Graham and Harvey (2001) make use of a survey of CFOs to outline that flexibility and the minimisation of interest obligation is one of the most important factors. However, other authors clearly criticise the model of Myers and Shyam-Sunder for not considering equity issuance (Chirinko and Singha, 2000). At this point clear limitations of the theory can be seen, because in certain situations, e.g. financial distress (Guzhva and Pagiavlas, 2003), a company would prefer equity to debt financing. Therefore, the models cannot be used to truly understand every capital structure (Rahman and Arifuzzaman, 2014), but nevertheless it is a good base for companies financing behaviour (Shyam-Sunder and Myers, 1999).

4.2 Trade-Off Theory

In contrast to the pecking theory, the trade-off theory implies an optimal debt-to-equity ratio (Graham and Harvey, 2000). As shown in the graph below, the key issue of a company according to this theory is to find the optimum between tax advantages of debt and costs of financial distress (Shyam-Sunder and Myers, 1999).

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Diagram 6: Trade-Off-Theory (Own illustration based on Shyam-Sunder and Myers, 1999, p. 220)

In literature more advantages of equity compared to debt, e.g. lower costs (issuance and serving), fixed maturity, no release of control, are listed (Damodaran, 2011, p. 444). However, the practical application is discussed controversially. Some authors criticise Shyam-Sunder and Myers work and argue for a negative correlation between leverage and profitability (Rajan and Zingales, 1995, p. 1457), some companies struggle with finding the right relation between debt and equity and end up before or after the optimum. Finally, on the base of empirical studies it could be staid that the theory can give false as well as right results and is rather adequate for companies in special situations (Adedeji, 2002). Tesco, for example, being active in a rather stable market, as the demand for groceries will even continue in crisis’s (Anagboso and McLaren, 2009, p. 28), could be assumed to follow this strategy. Steadily increasing its gearing ratio within the last five years, considering benefits of equity financing and keeping up a high proportion of debt, the company can make use of the tax deductibility of its interest payments.

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Details

Seiten
21
Jahr
2015
ISBN (eBook)
9783668149953
ISBN (Buch)
9783668149960
Dateigröße
1 MB
Sprache
Englisch
Katalognummer
v315138
Institution / Hochschule
University of South Wales
Note
85%
Schlagworte
Financial Management Gearing Policy Dividend Policy Capital Structure Policy Financing Policies Critical analysis

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Titel: Critical Analysis Of The Financing Policies of Tesco plc