Evaluation of Tesco Plc

            Tesco Plc is a public owned company listed in the London Stock Exchange and several other major stock exchanges. Tesco retails food, nonfood, electronics and other associated activities in the UK, parts of Europe, Asia and recently the USA. It is the largest retailer in the UK with estimated market capitalization of approximately £32B.

WACC – Weighted average cost of capital

            This is basically the minimum rate of return that the company’s investments or projects must meet in order to be accepted. Shareholders of a company demand a certain minimum rate for investing in the company. This is what is called the cost of capital. The cost of capital is used to discount projects/investments to evaluate whether they can be accepted or not.

WACC is calculated by taking the component cost of capital and multiplying it with the proportion of that component cost of capital to the total capital structure.

            The sources of financing in a company are equity, preferred shares, retained earnings and debt. Each of these sources of finance has different costs to the company. Weighted average cost of capital evaluates the cost of capital of new sources of funds and therefore the market values of the component cost of capital is used. WACC is calculated using the following formula.

            WACC = K_e We + K_d (1-t) W_d + K_p W_p

Where K_e = cost of equity (including retained earnings)

            W_e = proportion of equity to total capital

            K_d = cost of debt

            T    = tax rate

            K_p = cost of preferences shares

            W_p = proportion of preference shares

Cost of equity

            This is the least rate of return demanded by the shareholders for investing their funds in the company. It is basically what the investors demand for assuming the risk of investing in the company. There are two methods of calculating the cost of equity;

1. Cost of equity = dividends in period 1 (one year from now)

Market price of shares                             + growth rate of dividends.

                         OR

1. Cost of equity = risk free rate + Beta (return of market – risk free rate)

Return of market – risk free rate = risk premium (nettle@Africa, Pg. 27: 2008).

Using formula two

• The cost of debt = 5% (coupon rate) –this is the cost of 10 year UK government bond (Bloomberg 2008)
• The equity beta of Tesco Plc. = 0.7651 obtained from (UK Yahoo Finance 2008)
• The equity risk premium for UK shares is 4.61%. (Morningstar 2008)

Therefore the cost of equity, Ke

                                               = 5% + 07651 (4.61)

                                               = 8.537%

The risk free rate is the rate of 10 year UK government bond.

Cost of debt

            This is the rate at which the company pays the interest on the outstanding debt. Debts issued by the company can be redeemable or irredeemable. The cost of redeemable debt is estimated as below

            K_d = interest

Amount (value of debt)

Cost of the irredeemable debt is calculated as follows

            Yield to maturity (YTM) = interest (coupon value – market value)/n

                                                           Coupon value + market value/2

            Where n = number of periods to maturity in years (nettle@Africa, Pg. 27: 2008).

Tesco Plc has many debts and therefore the cost of debt is the weighted effective interest rate for each debt.

9.2 x 147 + 5.9 x 130 + 6.0 x 352 + 5.8 x 190 + 6.7 x 153 + 6.2 x 525 + 5.9 x 340 + 6.6 x

         4146           4146          4146            4146           4146            4146          4146

6.6 x 244 + 5.6 x 349 + 5.1 x 361 + 5.9 x 243 + 6.0 x 198 + 5.6 x 197 + 46 x 206 + 5.1 x

        4146           4146           4146            4146           4146            4146          4146

306 + 2.2 x 176 + 4.9 x   29

4146           4146          4146   = 5.736%

Weighted average cost of capital schedule

Source                        amount           proportion     cost (%)          after tax         WACC

Equity             10571              0.72                 8.537               8.537               6.147

Debt                1446                0.28                 5.73                 4.015               1.124

                        14717                                                                                    7.271%

            The WACC for Tesco Plc is calculated to be 7.271%. In the calculation of the cost of equity, the assumption made is that the equity premium used is for all the listed shares in the UK capital markets.

The risk free rate is also assumed to be equal to the 10 year UK government coupon rate. The cost of debt calculation involves the use of the effective interest rates as listed in the annual report of the company. The company has used leases to finance its operations. Therefore the total debt is the normal debt plus leases.

 The effective interest rates are weighed with the proportion of each type of debt in order to get the total cost of debt. It is also important to note that we could not use the yield to maturity formula because the information on the annual report does not provide for the coupon values and market values of these debts. Therefore the cost of debt is the weighted effective interest rate for each type of debt and leases.

In the WACC schedule, the amount of equity and debt is taken from the balance sheet in the annual report. These amounts are then summed to arrive at the total capital structure. The proportion of each source of financing is calculated by taking the proportion of each source over the total amount.

The cost of debt is usually lower than all the sources of finance because the interest on the debt is tax allowable and hence the cost of debt is the after tax cost. Tesco Plc tax rate is calculated as follows;

            Tax rate =       tax amount                 = 772

                                   Taxable income            2653              = 30%

Therefore the after tax cost of debt = 5.736 x (1 – tax rate)

                                   = 5.736 (1 – 0.3)

                                   = 4.015%

Tesco Plc. Cash flow

            The cash flow statement is divided into three types of cash flows i.e. cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. Cash flow is quite different from profits in that the cash flow statement determines the movement of cash in the company while profit and loss statement evaluates the incomes and expenses. This is why a company must manage its cash flows very well because profitability does not mean cash. This is why cash is considered superior to profits in some cases.

Operating cash flows

            This is basically the cash flow from the main core activities/ business of the company. Operating cash flows should be at all times positive because negative cash flows indicates that the company is not meeting its objective of existence. The net operating cash flow of the company declined marginally from the 2006 figures. In 2006 the operating cash flow was £ 2,619,000,000 compared to £2,611,000,000 in 2007. This is however due to the increased cash and interest payments in 2007 otherwise the operating cash flow increased to £3,532,000,000 up from £ 3,412,000,000. Therefore, the company is meeting its objectives of existence as indicated by the positive cash flows. Operating cash flow is the driving force in the company.

Investing cash flow

            This is cash flow generated from the investments that the company engages in. it results from disposals and acquisitions. The investing cash flow of Tesco Plc decreased from (£ 1,962,000,000) in 2006 to (£ 2,343,000,000) in 2007. This means that the company invested a lot in its expansion and hence a lot of cash moved out of the company.

Financing cash flows

            Financing cash flows is as a result of movement in shares, dividends paid out, loans and other activities that are used in financing the company’s operations/assets. The cash flow decreased from (£ 492,000,000) in 2006 to (£533,000,000) in 2007. The driving force behind this drop in cash flow is the share repurchase undertaken by the company, repayment of debts as well as increase in dividends paid out.

Discounting rate

            In evaluating investment projects, companies usually look at the expected future cash flow of the various investment alternatives. The expected future cash flows need to be evaluated in current period monetary terms to decide whether to accept or reject in project.

In evaluating these cash flows, a discounting factor is used to calculate the cash flows in present terms. A discounting rate is that rate with which the firm’s investment projects are evaluated. Most companies usually use the WACC to evaluate their investment projects. The discounting rate should be appropriate in order to make sound investment choices (Expectationsinvesting, 2008).

The discounting rate to be used should take into consideration various aspects; key among these include interest rates (real) on alternative investments, effects of inflation on the profitability of the project, effects of changing economic trends, project duration period and the amount of resources needed for the project (Goodpasture, Pg. 137: 2003).

It is for this reason that companies usually apply different discounting rates to various projects of the company however projects similar in nature should be discounted using one rate so as to make reasonable comparisons between the proposed investments. (Goodpasture, Pg. 137: 2003).

            As discussed earlier, some companies use WACC to evaluate the various investment projects. If this is the case of Tesco Plc., then its WACC might be too low so as to lead to the company making in correct decisions. The company should evaluate its major investment projects using a more appropriate rate since their projects tend to have major financial implications should they fail. Therefore the discount rate to be used by the company in its major projects should be sufficient in evaluating the investment policy.

References:

Bloomberg L. P (2008). Rates and Bonds. UK Government Bonds. (Online). Available:

http://www.bloomberg.com/markets/rates/uk.html 7/4/2008

Expectationsinvesting, (2008). Online Tutorial #8: How Do You Calculate A. Company’s

 Cost of Capital? (Online). Available:

http://www.expectationsinvesting.com/tutorial8.shtml 7/4/2008

Goodpasture J, C (2003).  Quantitative Methods in Management. Discounted cash flow. J

 Publishing. Pg. 137-138

nettle@Africa, (2008). Session 2: cost of debt and Equity Capital. (Online). Available:

http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page27.htm pgs. 27-36

 7/4/2008

Morningstar, (2008). United Kingdom Risk Premia Over Time Report. (Online).

 Available:

http://corporate.morningstar.com/ib/asp/subject.aspx?xmlfile=1424.xml 7/4/2008

Tesco Annual reports. Available at: http://www.tescocorporate.com/page.aspx?pointerid=40B6E68B255B44ECADF894ACA012D4FF. Accessed on 07.04.08

Yahoo Finance, (2008). Tesco Plc (TESCO.L), Detailed Technical Analysis. (Online).

 Available:

http://uk.finance.yahoo.com/q/tt?s=TSCO.L7/4/2008 7/4/2008