Capital Structure Of Economic Perspectives: Tesco Case Study

Theories of Capital Structure: Franco Modigliani and Merton Miller Approach

Discuss About The Capital Structure Of Economic Perspectives.

Franco Modigliani and Merton Miller have given the theory that company’s value is independent of its capital structure. According to them, there will be no change in the company’s value if its debt and equity funding will change. The company always gives the same return irrespective of its structural components. The aim of capital structure is to maximize the wealth of the business and minimize the cost of capital (Cho, El Ghoul, Guedhami and Suh, 2014). The company will not give the same returns when equity and debts remain same over the years. Let’s discuss whether the Tesco company value is dependent on its capital structure or not.

Capital structure is the way how a company collects its funds from the market to purchase assets and fund its operations. The capital structure can be defined as the ratio of debt and equity. Debt and equity are equally important in a capital structure as, without any of them, capital structure is not adequate. An optimal ideal ratio is 2:1 in which there should be equity and half of equity, debt should be there. Debt comes in the form of debentures, loans, bonds etc. and equity comprises of retained earnings, preference shares, and equity shares. A capital structure without debt is considered to be less profitable. The inclusion of debt increases the earning per share of business as the interest payable on debt fund is deductible in tax calculation, which leads to rising in share price (Building the Business Case, 2018). A company without debt in its structure has to pay more tax as interest deduction is not there. Capital structure helps increase the value of the business, minimizing the cost of capital for the firm etc.

This approach has been devised 40 years ago by the Franco Modigliani and Merton Miller. According to MM Approach, cost of capital is independent of the capital structure and there exists no optimal value. According to MM Approach, the value of a firm which uses debt in its capital structure (leveraged firm) is the same as the value of a firm which uses the only equity in its capital structure(unleveraged firm) if the operating profits and future aspects are same. MM proved his theory using arbitrage process. In this process, if the process of financing and market value of two companies are same then MM model will exist in its structure (Myers, 2001).

Capital Structure of Tesco

Modigliani and Miller assumed that there will be perfect competition in the market. There is no transaction cost and taxes paid by the company. Finance through debt funds does not affect the earnings before interest and tax. MM theory first proposed that the market value of any business is not dependent on its capital structure and any change in the gearing ratio cannot affect the company cash flows (Capital Structure Theory – Modigliani and Miller Approach, 2018). Another MM theory proposed that the rate of return will increase when the debt-equity ratio will increase. That means both equity and debt increased then only the returns to a shareholder will increase. Lastly, MM theory proposed that the average cost of capital will come same when applying in the market in the form of investment irrespective of the nature and type of funds or securities used. There will be complete separation of the investment and financing decision.

Tesco plc, headquartered in England, is a leading grocery retailer founded in 1929. Tesco is considered to be the second largest global retailer leader in terms of profits. Tesco performs the cash and carry activities and preserves the store including warehouses, departmental stores, and supermarkets in more than 12 countries. Tesco is listed on the London Stock Exchange (TESCO PLC, 2018). The subsidiaries of Tesco are Tesco Bank, Booker Group, Tesco Ireland etc. Nowadays, company is involved in other sectors also like coffee shops, telecoms, petrol stations, gold exchange services, internet retailing, financial services etc. Tesco is still planning g to expand its business to other areas also to become the leader in the market. Tesco has many competitors in the market but which include ASDA, Sainsbury’s and Morrison’s, they are also called the big four in the United Kingdom (Fortune, 2018). The objectives of the company are to run a business successfully and maximizing the wealth of the shareholders. In its capital structure, both equity and debt is used while financing the activities and assets.

Particulars	2013	2014	2015	2016	2017
	AUD$	AUD$	AUD$	AUD$	AUD$
EBIT	2188	2631	5792	1072	1017
Interest expense	459	564	661	878	874
Total Liabilities	14,483	14,043	17333	17422	20034
Long term loans	10,068	1,910	2008	10711	9433
Shareholders’ Equity	16,661	14,722	7071	8616	6414

Years	2013	2014	2015	2016	2017
Debt- equity	0.87	0.95	2.45	2.02	3.12
Interest coverage ratio	4.77	4.66	8.76	1.22	1.16
Market Price	386.50	296.05	243.10	179.50	183

According to Kayo and Kimura (2011) said that the managers will work more efficiently and effectively when there is an increase in the ratio of debt to equity. Business managers are come up with extra funds in form of cash to the shareholders rather than utilizing those funds in the negative net present value of projects. Since the managers will have to make sure that the debt obligations of the firm are paid on time. Hence with the rise in debt funds of the company the creditors and shareholders become the main party in the corporate governance structure. This means that the leverage firms are better than unleveraged for owners as debt level can be used for supervising the managers.

Analysis of Financial Data of Tesco

Debt funds include the loans and borrowings, debentures and bonds. Talking about the company structure of the Tesco, total liabilities of the company is increasing every year so as the earnings of the company. In the year 2014, total liabilities of the company were $14,043 which is lowest borrowings (Tesco Plc, 2014). After 2014 company has an expansion plan, so for that Tesco has taken a loan. In the year 2015, the overall debts of the company have been increased due to diversification in its activities. This is the reason debt-equity ratio has been increased in the table from .95 to 2.45. The earnings of the company have been continuously decreasing due to the increased in the interest payment by the company for the loan. The interest coverage ratio has been increased in 2015 and come out to be 8.76 times. In the year 2016-17, the long-term liabilities has been decreased but the total liabilities have been increased, so it implies that the company has been started to pay their loans. The interest coverage ratio has also been decreased from 1.22 to 1.16 times in the year 2016-17. Interest coverage ratio provides information about the covering of interest payable by the earning before profit and tax (EBIT) (Infront Analytics, 2018). There is an increasing trend shown in the ratio of company Tesco Plc which shows that the lenders bear more risk and they are sure that their interest will be given back in time by the company (Bartleby.com, 2016).

Due to rise in the borrowings of the company, owner’s capital i.e. equity of the company are showing the downward trend in the ratio analysis, shareholders are losing their control over the holdings of the company (Market Watch, 2018). The earnings of the company in the year 2014-15 have been decreasing due to the involvement of debts in the capital structure. The market price of the company has also increased as there is a direct relationship between the shareholder’s wealth and equity of the company. If the shareholders of the company earn then the company will always be in profit. In the year 2015-2016, the earning before profit and tax (EBIT) has been decreasing $5792 to $1072 and the market price of the Tesco too from $243.10 to $179.50 (Tesco Plc, 2016). In the year 2016-17, the company has repaid its debt so there is a rise in the debt-equity ratio also.

Impact of Debt on Tesco’s Market Value

The company should have both debt and equity in its capital structure. Company’s gains more when the debt the in the capital structure as profits are the reward for taking the risk.  Profit increases only when there is greater the debt-equity ratio of the company (Tesco Plc, 2013). In Tesco Plc, initially there will be fewer earnings to the company because of the increase in debts but the return of the debts will be long term. So borrowings and expansion plan of the company will give returns in near future (TSCO TESCO PLC ORD 5P, 2018).

Conclusion

From the above explanation, we can conclude that the company’s value is dependent on the capital structure of the company. Capital structure is the ratio of debt and equity. Tesco Plc has more debt funds in its structure and less of equity funds. Tesco Company’s value is dependent on the capital structure of its company. There is increased in debt funds of Tesco, the market price per share of the firm starts declining. There is the impact on the company’s value because of the debt funds in its structure. It is very clear from the above discussion that the market value of the company will vary when there is a change in the debt or equity funds of the company.MM approach does not hold true in Tesco Company due to its assumptions of the theory.

References

Bartleby.com. (2016) Analyzing Tesco’s Capital Structure and Cost of Capital. [online]. Available at: https://www.globalcapital.com/article/k39kwlmxhlkn/interview-coca-cola-amatil-faces-challenges-in-managing-credit-risk. [Accessed on 12^th April 2018]

Building the Business Case. (2018). Financial Structure, Capital Structure Capitalization, Leverage [online]. Available at: https://www.business-case-analysis.com/capital-and-financial-structure.html [Accessed on 18^th April 2018]

Capital Structure Theory – Modigliani and Miller (MM) Approach. (2018).Capital structure Theory [online]. Available at: https://efinancemanagement.com/financial-leverage/capital-structure-theory-modigliani-and-miller-mm-approach [Accessed on 12^th April 2018]

Cho, S.S., El Ghoul, S., Guedhami, O. and Suh, J. (2014) Creditor rights and capital structure: Evidence from international data. Journal of Corporate Finance, 25, pp.40-60

Fortune. (2018).Tesco grows its market share for the first time in five years [online]. Available at: https://fortune.com/2016/10/18/tesco-sainsburys-market-share/. [Accessed on 14^th April 2018]

Infront Analytics. (2018) Ratios valuation of Tesco PLC [online]. https://www.infrontanalytics.com/fe-EN/01841EX/Tesco-PLC/financial-ratios. [ACCESSED ON 12^th April 2018]

Kayo, E.K. and Kimura, H. (2011) Hierarchical determinants of capital structure. Journal of Banking & Finance, 35(2), pp.358-371.

Market Watch. (2018) Tesco Plc [online]. Available at: https://www.marketwatch.com/investing/stock/tsco/profile?countrycode=uk [Accessed on 12^th April 2018]

Myers, S.C. (2001). Capital structure. Journal of Economic perspectives, 15(2), pp.81-102.

Tesco Plc. (2013). Annual reports [online]. Available at: https://www.tescoplc.com/media/1456/tesco_annual_report_2013.pdf. [Accessed on 12^th April 2018]

Tesco Plc. (2015) Interview Annual reports and Financial Statements. [online]. Available at: https://www.tescoplc.com/media/1426/tescoar15.pdf [Accessed on 12^th April 2018]

Tesco Plc. (2016). Annual reports and Financial Statements [online]. Available at: https://www.tescoplc.com/media/264194/annual-report-2016.pdf. [Accessed on 12^th April 2018]

Tesco Plc. (2018). Levered/unlevered beta of Tesco Plc [online]. Available at: https://www.infrontanalytics.com/fe-EN/01841EX/Tesco-PLC/financial-ratios. [Accessed on 12^th April 2018]

TESCO PLC. (2018). Share price information [online]. Available at: https://www.tescoplc.com/investors/share-price-information/share-price/. [Accessed on 14^th April 2018]

TSCO TESCO PLC ORD 5P. (2018) London Stock Exchange [online]. Available at: https://www.londonstockexchange.com/exchange/prices-and-markets/stocks/exchange-insight/trade-data.html?fourWayKey=GB0008847096GBGBXSET1. [Accessed on 14^th April 2018]