The following report analyzes the proposed business venture by Asdy Plc to enter the UK grocery market. The feasibility of the project was ascertained by using the NPV and Payback criterion appraisal techniques. Despite the project being profitable in the long run, associated risks as well as loan repayment restrictions require further planning and considerations.
Introduction
The grocery industry in the UK forms an integral part of the aggregate consumer spending and was valued at £156.8 billion in 2011 (IGD, 2012), an increase of 3.8% year -on-year. The growth of this industry over the years can be seen in Appendix One. Expenditure on food and grocery items constitutes 53p in every £1 of retail spending (IGD, 2012), underscoring the importance of this industry as a cornerstone in the consumer spending landscape of the country. All of the 88,441 UK grocery stores in UK can be divided into four broad categories:
Convenience Retailing
Traditional Retail
Hypermarkets, Supermarkets and Superstores
Online
As per our business interests, it should be noted that the Supermarket and Superstores category contributes to £111.4 billion of the total grocery industry, as shown in Appendix Two.
Motivation
Asdy Plc is considering the proposal of entering the UK grocery retail industry in line with their business strategy of attaining international reach. The following report is an analysis of the proposed business venture based on certain appraisal techniques and the associated risks.
Project Proposal
2.1 NPV
As per initial estimates, the cost of setting up the new store to operational status will be £20,000,000 and the company's cost of capital has been estimated at 5%. In order to bridge the financing gap between the project cost and the company's internal funds, a long term bank loan has been arranged. The following tables outlines the expected free cash flows that the company is expected to obtain from operations:
Free Cash Flows
Time line
Years 1 - 3
Years 4 - 8
Year 8 onwards
Yearly breakdown
Receive £1,000,000 for 3 years
Grow @ 10% per year
Grow @ 2% per year
Aggregate amount
£3,000,000
£5,105,100
£73,205,000
Discounted to t = 0
£56,158,034
After taking into consideration the initial outlay of £20,000,000, the NPV of the project is £36,158,034. This indicates that the business proposition of entering the UK grocery market is a financially viable and will lead to positive returns in the future.
2.2 Payback Criterion
Provided the maximum loan term tenor granted is ten years, the payback criterion gives us a time line of 14.47 years, which translates into a minimum repayment period of 14 years and 6 months. This is conditional on the yearly free cash flows being used in their entirety to fund the loan repayment. Therefore, despite the profitability of the project, the proposed means of financing is not ideal for such a project where the returns are mainly realized in the long term. The company should look into other financing venues like generating equity through issuance of shares which can secure funds for the project without the pressure of early repayments.
Key Risks and Mitigants
3.1 Loan Repayments
As mentioned above, the payback period for the loan exceeds the maximum tenor available. Therefore arrangements must be made to look into others means of financing. In addition to this, it should be noted that the payback period is dependent on free cash flows estimates. Given the uncertain nature of this business venture, that is the initial transition into an industry, these cash flow estimates can be subject to change, which furthermore puts the loan repayment capacity at risk.
As a possible solution, the company can enter into a loan guarantee contract, whereby repayments are guaranteed by a third party. There will be a commission charged for this service, but provided that the company might be in need of future term loan arrangements, it is imperative that the loan repayments are made on schedule to avoid a negative impact on the company's credit history.
3.2 Business environment
Before a new business venture is undertaken, the prevalent industry environment must be studied to arrive at a strategy for success. Given the developed and sophisticated nature of the UK grocery industry, the company, being a small scale entrant, must adopt existing strategies used by other players of equal size and scale like Waitrose and M&S which have managed to create and maintain a niche for themselves under such competitive circumstances. to remain competitive.
Five supermarket chains account for almost 83% of the UK grocery industry. The biggest three players include the market leader Tesco, with 30.6% of the market share. It is followed by Asda / Wal-Mart with a 17.2% share and Sainsbury with 16.2%. The breakup of market share (2010) is listed below:
Market Share of UK grocery firms (%)
Tesco
30.6
Asda / Wal-Mart
17.2
Sainsbury
16.2
Morrison's
11.7
The Cooperative
6.8
Waitrose
4.2
The latest trends developing in the UK grocery industry indicate towards a increased competitiveness; this is evidenced by a report which states that "according to J Sainsbury, it (Sainsbury) plans to open between 50 and 100 convenience stores a year, and Tesco has announced 150 openings" (Euromonitor, 2012). Despite such expansion, small scale chains have created their market share by differentiated positioning of products and creating private labels which have created a sense of loyalty amongst customers. Waitrose is one such chain which has created a brand image that attracts an elite customer base by utilizing private labels and underscoring its exclusivity by holding a Royal Warrant with the Queen for the supply of wines and spirits (Waitrose, 2012). Therefore the dynamics of the UK grocery market chains is characterized by "'value for money', customer service and the retention of their customer base" (Short and Constanzo, 1999).
US products already enjoy substantial accessibility and recognition in the UK retail markets; however, in order to carve out a loyal customer base, the company will not only have to set aside a substantial advertising budget but also present a fresh and unique product catalogue. Again the introduction of new products must be done after taking into account the tastes of the local population.
3.3 Product Introduction
A supermarket's product catalogue is the most important driver in the success of the chain. The US is the largest non-EU country supplier to the UK (Julie Vasquez-Nicholson, 2011); however the access of British markets to EU suppliers can be a hurdle for foreign producers. UK markets especially enjoy the presence of specialty products like Italian cheese and Spanish citrus, which along with the duty free supply terms that the EU enjoys can create tough circumstances for US producers to dent the monopoly of these products. On the other hand, the UK has levied an import duty on US imports, which can go up to 25% depending on the product.
The company can better handle these market conditions by undertaking an overview of their product catalogue and balancing it by having a combination of products produced in the US and products from local suppliers. Specialty produced available only in the US will create a niche in the local market whereas the local suppliers can reduce the company's costs on account of lower duties.
Appraisal Techniques: Advantages and Disadvantages
4.1 NPV Advantages
Net Present Value (NPV) takes into account the time value of money. This means that future cash flows resulting from the business venture can be discounted back to see whether the costs spent on the project will be offset by future profits. Other advantages of this appraisal technique are that it takes into account the cost of capital of the company, which can include borrowed funds or freshly injected equity. NPV also provides the return on the project in monetary terms which gives an estimate of the project's contribution towards increasing company value.
4.2 NPV Disadvantages
The shortcomings in NPV calculations come from uncertainty in future cash flows. The cash flows used as inputs in calculating the net present value of a project can change significantly depending on future internal issues of the company or changing market conditions. The NPV calculation provides the potential benefit in monetary terms while in some cases managers might want to know the overall return on a business venture depending on the amount invested; this percentage return is not included in the NPV.
4.3 Payback Criterion Advantages
This appraisal technique is usually used as an initial screening to determine the feasibility of a project based on a time line that the manager has set. It is simple to calculate and can be used to evaluate the possibility of risks that could arise in a project due to liquidity issues and uncertainty from a long payback period.
4.4 Payback Criterion Disadvantages
Since this is a basic appraisal technique, it has a lot of shortcomings. It does not take into account the time value of money. Furthermore, it neither takes into account the timing of cash flows within the payback period nor the cash flows after the payback period, which means it will rank those projects better which provide better returns in the near future regardless of total profitability of the project.
Conclusion
As evidenced in the report, despite the competitiveness in the UK grocery market there is potential for growth. Even though the market is dominated by certain big players, smaller chains similar to Asdy Plc have created a niche for themselves through private labels and product differentiation. The projected cash flows indicate that the proposed business venture is profitable in the long run; however, given the tenor of the bank loan available and the payback period that extends this tenor, the company should look towards other venues for financing. At the same time, the company should be wary of the potentials risks present in this project and take the necessary steps to mitigate the same.
