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Wealth Management: Capital Model Add in library

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Question:

1-The various external sources of finance clearly identified, carefully explained and distinguished. ?

2-The possible considerations that may have been taken into account by the management when choosing the type of finance. Remember that all financing decisions are not taken on purely financial/quantitative considerations. Are there other factors that may have influenced capital structure decisions?

3 - An attempt at the calculation of the WACC of the company within the published information available. Students should be demonstrating the ability to obtain data and use these to support their calculations. The main emphasis of the numerical analysis will be the ability to interpret and apply the results. A critical awareness of the financial models used is required along with their limitations and underlying assumptions.?

 

Answer:

Introduction

Objectives of the assignment include:

To state the various sources of external funding options available to a company.

To explain the features of the various funding sources in detail.

To study the various factors to be taken into account by the Management when choosing a particular source of financing; including conditioning factors within the local and globalised markets.

To calculate the Weighted Average Cost of Capital (WACC) of the firm based on the existing capital structure of funds.

As a multi-national company, there are several options available for external financing. Apart from the traditional forms of equity, there are many other options in the capital (Long-term) markets like debentures, preference share capital, long term loans and many others. Depending upon the current financial status of the company and after careful study of the micro and macro economic conditions should a company come to a decision about the source of fund to be employed. All options have various distinct characteristics and these options suit different companies differently. These are crucial decisions to be taken by the Management as this impact the future capacity of the company and more importantly the stake holder value. Also the determination of the cost of capital paves the way to reduce the various components contributing to that cost.

Context of the Company

TESCO, Britain’s leading food retailer, is the third largest globally in the segment. Incorporated in November 1947, the Company started pioneering several new innovations. It developed new concepts like Tesco Metro (city centre store for local shoppers) and Tesco express (first UK petrol station convenience store). The Company, through its subsidiaries offers services in segments like telecom, digital entertainment and banking. Tesco started its International operations from the year 1994, which now accounts for half of its retail space. The Company main focus has been on the non-food sales both in store and online mode, making Tesco UK’s largest CD retailer.

Tesco’s banking products include customer accounts for credit cards, loans, mortgages and savings. The company operates in the countries of UK, China, the Czech Republic, Hungary, Ireland, India, Japan, Malaysia, South Korea, Turkey and many others.

Clubcard, Tesco’s most successful loyalty card, helps attract customers and bring them into their fold.

There are 2 key technological sources of innovation in the retail segment: online provisions market and improved supply chain. Both require improvement in efficiency, as these are highly customer focused areas.

The Company operates around 3378 stores in UK, 2417 stores in Asia and 1510 stores across Europe. Further the company offers almost 4000 own brands under its label (December 2014).

Main Body

External Sources of Finance

Apart from the issue of equity capital, bonds provide a very convenient option to companies to raise long-term capital. Bonds/Debentures represent the amount of capital indebted by the company to the bond holder. The bonds/debentures pay out periodic (usually Semi-annually) payments to its holders, based upon a certain coupon rate and the tenure of the bond finalized at the time of issue. The domestic bonds are issued in a particular company to domestic investors with tenors ranging from 1 to 30 years.

There are several types of debt instruments.

Non-Convertible Debentures are pure debt instruments that are issued with a specific coupon rate and tenor. The repayment is structured in one or more tranches.

Partly Convertible debentures have two portions- the Convertible and the non-Convertible portion. The non-convertible portion pays the periodic coupon interest during the tenor of repayment. The convertible part gets converted into equity shares depending upon the terms of conversion.

Zero Coupon bonds do not pay any interest to the investor. These are issued at a discount and redeemed at par; the differential being the payment out of such bonds to the investor.

Deep Discount Bonds are issued at a discount and redeemed at its face value.

Floating rate bonds offer interests that are pegged to the indices such as the Treasury bill interest rate or the LIBOR. Such floating rate instruments reduce the inflation risk since the coupon is linked to the current interest rate, which, in turn, is impacted by the rate of inflation.

Foreign Currency Convertible Bonds (FCCBs) are instruments that provide a mix of debt and equity. After paying the interest and the principal payments, these bonds provide the bondholder with an option to convert the bond into stock. FCCB is issued in foreign currency, different to the issuer country’s domestic currency. These bonds are easily marketable as the investors enjoy the option of conversion in to equity if there are instances of capital appreciation.

Income bonds, similar to conventional bonds, make the coupon payments depending upon the company’s income.

Callable bonds provide the issuer to repurchase the entire bond issue at a predetermined price over a specified period of time.

A Put bond allows the bondholder to force the issuing company to buy back the bond at a specific price.

Equipref shares are fully convertible cumulative preference shares. One part of the instrument is converted into equity shares on the allotment date without any application. The other portion is redeemed at par value or converted to equity after a specific lock-in-period at the option of the investor at a slightly lesser price compared to the market price.

Foreign bonds are issued within the domestic capital market of a country by a foreign issuer for subscription exclusively by the domestic investors. The main feature of such foreign issue is the compliance with the local regulations in the country of issue.

Euro Bonds are issued and sold in the jurisdiction outside the country of denomination. These are external bonds to the domestic market of the country of denomination and not tied down to any location or individual domestic markets. Euro bonds are also issued as asset backed bonds that have structures that are rated.

The Euro bonds can also be tapped using the Medium Term Notes programme, which is useful for investors who need to tap the overseas bond market frequently. This programme allows for a standardized documentation platform to tap the bond market and makes it flexible for issuers to manage their financing requirements efficiently and cost effectively across a variety of maturity patterns and a diversified investor base.

Depository receipt is a security that represents ownership in a foreign security. It provides a useful mechanism for any company to get its shares listed on the stock exchange in the secondary market of the country where the securities are issued. It enables a company in one jurisdiction to issue depository receipts in other jurisdiction for individual investors.

Any depository receipt traded in the United States of America (USA) is called an American Depository Receipt or an ADR. If the depository receipt is traded in a country other than USA, it is called a Global Depository Receipt or a GDR.

Mortgaged backed Security (MBS) is a form of asset backed security that represents a claim on the cash flow of the issuing company via the mortgage loan. The loans derive value from the principals and are divided into various classes depending on the riskiness of the mortgages.

 

Considerations to be taken by the Management

Company’s Debt Structure: The Company has not had a consistent debt level over the past 5 years. The levels of debt as a means of external financing used by the company by a large extent, varying from 10520 (2015) to 529 (2013). The Company has been repaying the debt and has been issuing new debt over the past few years. Such debt could be taken by the Company for the development of new fixed assets. Debt would increase the financial leverage. The current leverage structure of the business is also to be considered before going for external modes of financing.
 
Growth: There is a close connection between External financing and Growth. All other things being the same, the higher the rate of growth in sales or assets, the greater would be the need for external financing. There is a need to establish the relationship between the External finance and growth is to be established to determine the level of financing,
 
Profit margin: An increase in the profit margin will increase the ability of the firm to generate funds internally and thereby reduce the requirement of external sources of funds.
 
Dividend policy: A decrease in the percentage of net profit, paid out as dividends to the shareholders, increases the retention ratio. This thereby increases the internally generated funds as equity and decreases the requirement for external finance.
 
Total asset turnover: An increase in the firm’s total asset turnover increases the sales generated for each pound spent on assets. This deceases the firm’s need for new assets as sales grows and hence increases the sustainable growth rate (maximum growth rate that the firm can achieve by keeping the debt-equity ratio constant). The increasing total asset turnover is considered synonymous with decreasing capital intensity.
 
Cost of funding: This forms a very important factor in selecting the source of finance. Debt usually comes at a lower cost compared to equity, because of the reward associated with the risk in investing in equity. Further, the interest rate of the debt is reduced by the tax benefits.
 
Future economic conditions: Any proper debt management plan would not be successful in taking into account all the needs of the upcoming years. Any operational shock may make the payment to the creditors difficult.
 
Credit rating: The cost of raising of new debt also depends on the previous financial transactions fulfilled by the company, the repayment of previous debt obligations and the prospects of the company for the years to come. The credit rating of the new debt issue by the company plays a crucial role in the rate of interest to be paid to the investors. The greater the risk the financier is exposed to, the higher the cost of capital for the company.
 
Repayment Terms: The period of the financing option constitutes an important consideration. Longer loans can lead to significant amount of interest to be paid over time. Further, the allocation of each payment towards the interest and principal helps determine the overall cost of the debt obligation.

 

Calculation of WACC

Weighted Average Cost of Capital (WACC) is the rate of capital that the company is expected to pay on average to all the security holders in order to finance its assets. A Company’s assets are financed with a combination of debt and equity. WACC constitutes the average of the costs of financing, each given a weight age as per its use in the situation.

 

Rf

2.27%

Debt *

18990.11

Rp

7.50%

Interest **

765.34

Beta

1

 

 

   

Wd

0.418472

Re

9.77%

Rd (Pre-tax)

4.03%

Equity

26389.5

Tax rate

12.83%

We

0.581528

 

 

 

 

Rd (Post-tax)

3.51%

WACC

7.15%

 

           

 

The Cost of equity is calculated on the basis of the Capital Asset Pricing Model (CAPM), which provides that the expected return on a security is linearly related to the stock’s beta.

Beta is a measure of the responsiveness of a security to movements in the market portfolio. It provides the amount of fluctuation in the price of the security in response to the changes in the value of the market portfolio.

The formula for the cost of equity is as follows: 

WACC gives an idea about the cost of funds employed by the company. The return on capital should be greater than the cost of capital in order to provide a positive return to the share holders. The CAPM takes into account the premium return for the risk undertaken for investing in securities, which is over and above the risk – free return.

The difference between the expected market return and the risk free rate is the risk premium, which is multiplied by the Beta value of the stock, to account for the risk taken fir investment in the stock. This is the additional return for the investor over the risk free rate obtained from the Government securities, which are of low risk nature and secured.

If the β = 0; then the expected return on the security is equals the risk free rate because the security has no relevant risk.

Since the β = 1; the expected rate of return on the security is equal to the expected return on the market, since the beta of the market portfolio is also 1.

The risk free rate in the UK is 2.27%, which is very less compared to India, where is ranges between 7% - 9%. The company has higher funds in the form of equity compared to debt.

The pre tax rate of debt is only 4% (Much cheaper source of fund compared to debts available at 12% in India). The tax rate being almost 13%, the post-tax cost of debt is 3.51%.

So, as and when the debt equity ratio of a company increases, the cost of capital of the company would reduce, since the debt is available at a lesser rate compared to equity.

The formula for Weighted Average Cost of Capital is

We = E/ (E + D); Wd = D / (E + D)

* The book value of debt was employed to do the calculation. (Adding the recent two-years average figures of Short term debt and Long term debt together)

** The latest fiscal year’s interest expense was divided by the two-year average amounts of debt to obtain the pre-tax cost of debt.

 

Conclusions and Recommendations:

The cost of capital plays a critical role in determining the cost of a new project or the cost of financing new assets. This gives an idea of the minimum return to be generated from the project or the asset. Asset beta (Beta of the assets of the firm is considered similar to equity beta) gives an idea of the risk involved with the purchase of the asset.
 
The estimate of beta for the project is also an important criterion. Sometimes, the project does not belong to any of the existing industry and in such cases; it would not be suitable to use the average beta figure pertaining to the project’s industry.
 
The corporate has an incentive to lower the trading costs because that will lower the overall cost of capital. One method of reducing the cost is by bringing in more uninformed investors, through stock split mechanism. However, the brokerage commission may increase on lower priced securities (Amihud and Mendelson).
 
The trading costs can be reduced by disclosing more information (Financial data and forecasts by management) by the corporate, thereby decreasing the gap between the informed and uninformed investors. Coller and Yohn confirmed that the spread between the bid-ask price is reduced after the release of such forecasts through a study.
 
Liquidity also plays a very important factor in determining the cost of capital of a firm. A firm may be able to reduce its cost of capital by taking adequate steps to improve liquidity.
 
The rate of debt available to the company is also dependent on the economic conditions prevailing in the domestic market. Changes in the Central Government policy rates, rating of the company, alternate sources of funds, and all these factors play a role in determination of the cost of debt borrowing to the company.
 
The costs of different sources of capital are to be compared with the internally generated cash flow which can be used as a cheaper source of financing.
 
Although debt provides a cheaper version of external financing compared to equity, debt adds up to the firm value only up to a certain level. The use of debt beyond a certain level puts pressure on the cash flow generation of the company and also deteriorates the firm value. Hence, the company should employ debt only upto the optimum level.
 
 
The cost of capital and return to the share holders also throws light on the concept of Economic Value Added (EVA). EVA is basically the surplus which is left after making appropriate charge for the capital employed by the firm.

EVA = NOPAT – c * Capital employed.

NOPAT = Net Operating Profit After Tax.

NOPAT = PBIT * (1-T)

EVA can be enhanced by lowering the cost of capital through altering the finance strategy.

The Cost of Capital is to be compared with the Returns on invested capital, which provides a measure of how well a company generates cash flow relative to the capital invested in its business. Any firm that continues to generate positive excess returns on its investments compared to the costs incurred to raise the capital needed for the investments is successful in earning excess returns. Such a firm will see an increase in its value as its growth increases. Whereas any firm that fails to earn sufficient returns compared to its cost of capital will destroy its value as it grows.

 

References:

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Chorafas, D. (2006). Wealth management. Oxford, UK: Butterworth-Heinemann.
 
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Hagigi, M., Sivakumar, K. and Wu, E. (n.d.). The Effect of the Need for Subsequent Equity Financing on Earnings Management Around Equity Financing. SSRN Journal.
 
Hannah, L. (n.d.). Funding Cost and a New Capital Model. SSRN Journal.
 
org, (2015). Tesco | Company Profile. [online] Available at: https://innovationleaders.org/tes_company_profile.html [Accessed 5 Jun. 2015].
 
Krivogorsky, V. and Joh, G. (n.d.). Debt Financing Decisions by European Firms. SSRN Journal.
 
Lake, H. (2015). Tesco's partnership with Diabetes UK raises £18.6m - UK Fundraising. [online] UK Fundraising. Available at: https://www.fundraising.co.uk/2015/02/26/tescos-partnership-diabetes-uk-raises-18-6m/ [Accessed 5 Jun. 2015].
 
Lavelle, K. (2004). The politics of equity finance in emerging markets. Oxford: Oxford University Press.
 
Martinsson, G. (2010). Equity financing and innovation: Is Europe different from the United States?. Journal of Banking & Finance, 34(6), pp.1215-1224.
 
barrons.com, (2014). TSCO Stock Price & News - Tesco PLC - Barron's. [online] Available at: https://online.barrons.com/quote/stock/uk/xlon/tsco [Accessed 5 Jun. 2015].
 
barrons.com, (2014). TSCO Stock Price & News - Tesco PLC - Barron's. [online] Available at: https://online.barrons.com/quote/stock/uk/xlon/tsco [Accessed 5 Jun. 2015].
 
co.uk, (2015). Debt management plan considerations. [online] Available at: https://www.piggybankrupt.co.uk/debt/dmp-considerations.html [Accessed 5 Jun. 2015].
 
Retail-week.com, (2013). Profile: Tesco - the UK’s largest retailer. [online] Available at: https://www.retail-week.com/home/profile-tesco-the-uks-largest-retailer/5046179.article [Accessed 5 Jun. 2015].
 
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Ross, S., Westerfield, R. and Jaffe, J. (2005). Corporate finance. Boston: McGraw-Hill/Irwin.
 
morningstar.com, (2015). Search Results: Tesco UK. [online] Available at: https://search.morningstar.com/sitesearch/search.aspx?s=o&q=Tesco%20UK [Accessed 5 Jun. 2015].
 
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Timmons, J., Spinelli, S. and Zacharakis, A. (2005). How to raise capital. New York: McGraw-Hill.
 
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