Finance and Investment
I. Introduction
The purpose of preparing this report is to analyse and investigate the capital structures and the cost of capital of Tesco plc and J Sainsbury plc. Tesco plc and J Sainsbury plc are both leading food retailers in the market providing both food and non-food products. This report is going to look at Tesco plc and J Sainsbury plc in food retailing market over the last 5 years (2005-2009), on how they performed compared to each other.
II. Food Retailing Market
Food retailing in the UK is a highly concentrated market, it accounts for around half the sales in the retail industry. The market is dominated by four major players: Tesco, J Sainsbury, Asda Group and Wm Morrison Group, covering 63% of all sales from the market. Figure2.1 shows the market shares of food retailers, as seen Tesco is the market leader with 25.7% of the market share.
III. Company Background
Tesco PLC
Tesco is currently the leading food retailer accounting for 25.7% of the sales made in the food retailing market (not including non-food items). Tesco Annual Report 2009 stated that they now operate in 14 different countries with 4,331 stores worldwide. It is the third largest food retailers in the world and the leading food retailer in the UK.
Most sales are made from food retail in Tesco, but non-food products sales have also enjoyed a healthy growth in the recent years. As consumers trading down from the high street to Tesco's value non-food products. Figure 2 shows the Tesco performance on non-food from 2005 to 2009.
J Sainsbury PLC
J Sainsbury is one of the major players in food retailing market in the UK. Sainsbury "was found in 1869, and today comprises 502 supermarkets and 290 convenience stores" (J Sainsbury plc, Annual Report and Financial Statements 2009. p.1). Over the last 5 years, Sainsbury sales has been growing, but at a steady rate (Figure 4.1), as mentioned in their annual report 2009 p.9, their performance in non-food sales has also grown with the star performer being the TU clothing range.
Looking at the basic data, both business has been performing fine, and appears that Tesco is doing better than Sainsbury in terms of sales and all other areas.
IV. Capital Structures
Tesco's Capital Structure
J Sainsbury's Capital Structure
In conclusion, from the data we can analyse that Tesco plc's common equity has been gradually swelling at a regular velocity while Sainsbury's equity capital is intermittent. Undoubtedly, both the organizations have increased their total debt over the period of time but Tesco's debt worth of its progress in the terms of their expansion in comparison to that of Sainsbury's growth. But when we look at the liabilities of the companies, we can say that Sainsbury's liabilities have come in control for the last three years and on the other hand Tesco's liabilities have been amplifying from 1998 till now.
V. Financial Ratios Analysis
Gearing
Gearing or Leverage is the relationship between equity and long-term borrowings. When a company borrows money, it has an obligation to make a series of interest payments and repay the principles to the creditors. When the company makes profits, the debt holders would continually receive only the fixed interests and the all the gains would go to shareholders. Therefore, gearing ratios measure financial leverage and determine how the firm's activities are funded by shareholders versus creditors.
On the other hand, Tesco's Return on Equity was 15.17% in the year 2005 which had been increasing constant till 2008 because of the growth of the company. Entry in the international market gave a boost to the company and it reached to the top of the mountain and today it has secured the largest share in UK's retail market and 3rd largest contribution in the international market. But in the year 2009 it fell by 1.28%, the major cause of it was economic downturn in the market. Overall performance of the company is good in comparison to that of Sainsbury's.
VI. Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is an economic model that has a relationship between risk and expected return in valuing or pricing financial securities for instance stocks, securities and financial derivatives (Value Base Management, 2009).
In practice, the investors prefer the higher expected returns if they involve in a higher expected risk; therefore, the CAPM formula that stated above is a simple equation to represent the idea that investors requires to be compensated in term of time value of money and risk. The time value is represented by rf (risk free rate) where the interest rate would be expected to receive from a risk-free securities such as Treasury Bill over a period of time (Money-Zine, 2004-2009). The second part of the equation is about risk and compensation of investors while undertake additional risk (INVESTOPEDIA, 2009). ß (beta) is an overall risk in placing an investment. All the companies have their own ß, if a company have beta of 2, it can be explained that that company has 2 times more risky than the overall market (TeachMeFinance, 1997-2009). Overall, CAPM model is the expected return of a security equals risk-free rate plus risk premium and the investors should not make the investment if the expected return is lower than their required return (INVESTOPEDIA, 2009).
VII. Weighted Average Cost of Capital
Weighted Average Cost of Capital (WACC) is expressed as a percentage and that is the minimum rate which a company is expected to pay for financing its existing assets (Answer, 2009). It is an overall return that a company must earn on existing assets in order to maintain its value or to satisfy creditors, owners and other capital providers (FinanceScholar, no date).
From the result of WACC, Tesco has a lower percentage than Sainsbury. It indicates that Tesco has to earn a 2.8% on its existing assets and business operation to maintain its value otherwise it may lead to decrease on its share prices. For Sainsbury, it will generate additional cash flow and may result in increase in share prices if it undertakes projects that have greater expected return than WACC. In conclusion, both companies should avoid investing projects that are under their WACC rate as it will result in the decrease in stockholder value as well as share prices.
VIII. Conclusion
It is evident from the above evaluation of the capital structures of Tesco PLC and J Sainsbury PLC that the increase in debt of Tesco is justifiable due to their large scale operations and international expansion. J Sainsbury's capital structure depicts their stagnant growth and equal proportions increase throughout the years. Additionally, Tesco's WACC is lower than J Sainsbury's which infers that Tesco is in a better position to raise capital at a lower rate enabling them to lower their overall costs and increase profitability.
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