Investment decisions companies make today will have a direct impact on their ability to reach financial objectives. Most companies are faced with questions such as: which projects should your company invest in, which returns are needed and what risks are the company willing to take to achieve company goals? This paper will explain what is, and how to calculate a weighted average cost of capital of Tesco Plc based on company’s balance sheet1 and cash flow statement. 2 The second part will focus on a report on the Tesco’s cash flow over the two year period starting in 2005.
In the last part essay will explain what discount rate Tesco Plc. should use when deciding on major investment projects. a) Calculate the company’s weighted average cost of capital and explain/justify your calculation. Weighted average cost of capital (WACC) is used to determine whether company should invest in a project. By comparing cost of capital on investment and expected return on capital, a company can decide whether investment is worthwhile.
Companies use this method as a discount rate for financed projects, because cost of capital is reasonable method to use to evaluate profitability of an investment.
Broadly speaking, a company’s assets are financed by either debt (less risky to creditors, so it has lover cost of capital) or equity (more risky to investors, so it has higher capital cost). Thus the capital structure of a company consists of three elements: preferred equity, common equity and debt. WACC is the average cost of these three components that takes their weight in to consideration and delivers the expected cost of new capital for the company. The measure is the overall required return on the finances employed as a whole; it is often used internally by company managers to judge expansion opportunities.
As mentioned before calculating WACC requires knowing the required rates of return for all of the sources of financial resources. Cost of capital is the true cost of securing founds that business uses to pay for its asset base. Calculation of Cost of capital of equity: ke = rf + RP Where: ke – cost of capital rf – risk free return, treasury bond with maturity of 10 years, RP – the risk premium, 1 – balance sheet – extracted from 2006 Annual Report of Tesco Plc. p. 46 2 – cash flow statement – extracted from 2006 Annual Report of Tesco Plc. p. 46
Risk premium is the extra return that stocks offer over what investors would pocket in risk-free investments, chiefly government bonds. It also takes the systematic risk into account, so the difference is multiplied by beta of the company. The risk premium arises from capital-asset pricing model (CAPM), where beta adjusts for correlation between share price and benchmark movements, therefore the final formula is: ke = rf + ? (rm – rf) Where: rf – risk free return, ? – Beta of a company, rm – expected return of market. Therefore for Tesco formula will look like this: ke = 4. 7% + 0. 60 (10. 1% – 4. 7%) ke = 8. 306% Second form of financing is debt capital which can be raised by taking out a loan or issuing corporate bonds. Generally, bonds pay higher rates than government bonds due to the increased risk, consequently the return and therefore risk are lower then on equity capital. A company that is highly geared has a high debt capital to equity capital ratio. For the purpose of WACC calculation cost of debt is ajusted by the corporate tax. therefore the formula is: kdat = kdbt (1 – T) Where: rf – risk free return, kdat – cost of capital after tax, kdbt – cost of capital before tax,
In the case of Tesco’s bonds, the redemption yield before tax is 7. 68%. That compares to the redemption yield on a gilt maturing at around the same time of about 4. 7%. The company pays 30% corporate tax, therefore the formula will be: kdat = 7. 68% (1 – 0. 3) kdat = 5. 376% From the calculation above it is clear that Tesco’s cost of capital of two sources of financing, debt and equity carry 5. 376% and 8. 306%, respectively. The next step is to calculate the actual weighted cost of capital. WACC is calculated by multiplying the cost of each capital component by its proportional weight and then summing:
WACC = ke We + kd Wd Where kd – cost of debt ke – cost of equity Wd – weight of debt– Vd / (Vd + Ve ) We – weight of equity – Ve / (Vd + Ve ) Data for Tesco is: Debt – ? 4,509 million Cost of debt – 5. 376% Weight of debt – 4,509 / (4,509 + 9 444) = 0. 3231 Equity – ? 9 444 million Cost of equity – 8. 306% Weight of equity – 9 444 / (4,509 + 9 444) = 0. 6768 WACC = 8. 306% x 0. 6768+5. 376% x 0. 3231 WACC = 7. 4407% Tesco’s weighted average cost of capital is 7. 44%, this means that if the company takes on an investment with return lesser than that figure it will make a loss.
Not being able to cover costs of financing will force shareholders to look for value elsewhere, consequently forcing them to look for returns in different company. Write a brief report on the company’s cash flow over the period covered by the accounts. Cash flow statement is simple and informative way to evaluate company’s financial position; both inflows and outflows of cash are included in the statement. Usually it is taken over the period of one year and it measure cash flow from: operation, investing and financing activities.
All of the figures are easily obtainable from the sheet. Tesco’s cash flow from net cash operating activities up 20. 4% to over ? 2. 6bn. Cash generated from operating activities was increased by just over ? 400m; interest paid by the company was higher although it was offset by lesser corporate tax paid. Second section, representing flows from investing activities increased to ? 1. 965bn, due to higher expenditure on property, plant and equipment, investment properties and tangible assets. The company also received fewer proceedings from the sale of assets, with net cash outflow of ? 23m. Equity investments made and dividends received were also down. In the section financing activities the company managed to decrease amount of cash used to finance its operations, it was done by paying off less of obligations under finance leases and smaller share buy-backs then year earlier. Management also eliminated new finance leases to zero and heavily increased repayment of its borrowing. Tesco’s cash flow statement looks healthy, cash generated over the 12 month period up 13. 4% to ? 3. 4bn. The company also issued ? 00m of new 50-year corporate bond that had to be moved in “Reconciliation of net cash flow to movement in net debt” with next debt increasing over ? 600m on year 2005. Give your opinion as to what discount rate the company should use when deciding on major capital investment projects. Justify your opinion(s) fully. There are two major methods to evaluate investments. The first one is Net Present Value (NPV) it shows the value of a stream of future cash flows discounted back to the present by some percentage that represents the minimum desired rate of return, company’s cost of capital.
The second, Internal Rate of Return (IRR) is a discount rate that delivers the net present value of zero for a series of future cash flow values. Both, IRR and NPV are widely used to decide which investments company should undertake, and which investments not to make. The major difference is that while Net Present Value is expressed in monetary units (Sterling or Dollars for example), the IRR is the true interest yield expected from an investment expressed as a percentage and it computes a break-even rate of return.
If a company takes on a project it must have the IRR at least equal to WACC of founds used to finance it. It is so because if WACC is lover then IRR the return on the project cannot even cover the capital employed to make the project happen. The increase of cash flow from 2005 to 2006 will be used as an estimated future cash flow and it is equal to 15. 6%. It is assumed that project will be run for three years and so, a table can be created. 2006200720082009 Year 0Year 1 Year 2Year 3 ?1325m? 1532m? 1771m? 2047m Adjusting for risk carries the great importance, in order to achieve reliable discount rate.
Two simple assumptions are made: the managers of Tesco can predict outcomes and there are only 3 levels of risk, low medium and high. Risk level Risk-free rate Risk premium Risk adjusted rate % % % LOW 4. 7 0. 3 5. 0 MIDIUM 4. 7 1. 3 6. 0 HIGH 4. 7 2. 3 7. 0 Calculating the Net Present Value the following formula is applied: NPV = CF0 + CF1 / (1 + k) + CF2 / (1 + k)2 + CF3 / (1 + k)3 Where: CF0 – cash flow at time 0 CFn / (1 + k)n – cash flow in year n K – risk-adjusted rate NPVL = – 4800 + 1532 / 1. 05 + 1771 / (1. 5)2 + 2047 / (1. 05)3 = 28. 5 NPVM = – 4800 + 1532 / 1. 06 + 1771 / (1. 06)2 + 2047 / (1. 06)3 = -64. 5 NPVH = – 4800 + 1532 / 1. 07 + 1771 / (1. 07)2 + 2047 / (1. 07)3 = -155. 3 With assumption that Tesco wants to purchase ? 4800m project, with the calculation above shows that project 1, with a discount rate of 5. 00% and a span of 3 years, projects that cash flows are worth $4,833. 67 today. It is greater than the initial $4,800. 00 paid. The resulting positive NPV of the above project is ? 28. 5m, which indicates that pursuing the above project may e optimal. Even though a project offers a positive NPV, the projected cash flows are still estimations. The accuracy of projected figures depends on the skill and experience of the analyst, and likelihood of these cash flows materialising depends on the financial risk associated with the type of project being pursued. Internal rate of return is essentially the interest rate that the project can generate for the company, and is calculated as the discount value that when applied in the NPV formula drives the NPV formula to zero.
Calculation of IRR is done by trial-and-error method: Cash flow Y1 Cash flow Yn NPV = 0 = Initial Investment + —————— + … ——————– (1+IRR)1 (1+IRR)n 1532 1771 2047 NPV = 0 = 4800 + ————— + ————— + ————– (1+0. 535)1 (1+0. 535)2 (1+0. 535)3 NPV = 0 for IRR = 5. 3564% When deciding whether to take on an investment, directors should calculate IRR as detailed above. If the investment is yielding at least 5. 564%, Tesco’s management should invest in the project, the higher IRR the better for the shareholder of the company. Bibliography/Reference: G Arnold, “Corporate Financial Management”, 3d edition, Pearson Education Limited. Charles P. Jones, Investment Analysis and Management http://www. tescocorporate. com http://www. bizhelp24. com/accounting/cash-flow-statement-3. html http://www. tescocorporate. com/annualreview06/pdf/report/Tesco_Report_2006_Full. pdf http://en. wikipedia. org/wiki/Cash_flow_statement http://www. learningmatters. com/idx/7871/
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