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  • Published on: 14th September 2019
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1. Company Overview

Tesco is Britain's leading food retailer and the third biggest globally. Tesco's first store was opened in 1929 in London. The early 1960s saw Tesco spread across the United Kingdom (UK). It was a moment for Tesco as the company started new innovations such as the opening of Tesco Metro for local shoppers, and Tesco Express, the first convenience store in UK. The first customer loyalty card ‘Clubcard' was introduced in 1995, and in 1997 entered a joint venture with the Royal Bank of Scotland as an entry point into the financial industry. The company keen on innovation lunched its website Tesco.com in 2000 to help take advantage of information technology.

Tesco started its international operations in 1994 and with over 480,000 employees, serving millions of customers a week in its stores and online platform. Representing in countries like Malaysia, Hungary, Czech Republic, Ireland, Poland, China and Slovakia (Tesco Plc, 2015).

2. Tesco's Cost of Capital

Tesco plc Cost of Capital is the rate of return that its bondholders and owners will be compensated with for their capital invested, since this is an opportunity cost of funds that could have been invested elsewhere. The assumption is that they will get more returns with Tesco than with other competitors.

Tesco's business financing is in two forms (debt and equity capital) as a business value creation and to make funds available for operations. Tesco's 2015 Annual Report identified its Market Value of Equity as USD20,749 and Market Value for its Debt as USD18,990. This makes the company having nearly 51% in equity and about 49% in debts as capitalization (Tesco Annual Report, 2015).

2.1. Estimated Weighted Average Cost of Capital (WACC) for Tesco

The WACC is very significant as this represents the complete requisite return on Tesco as a whole and its numerous use within Tesco operations and the external environment such as the market and the financial analysis. Tesco's operations and assets are financed by both Equity and Debt which forms the capital needed for operations. Therefore the need to calculate Tesco's WACC in terms of Equity Capital and Debt Capital. For the sake of this assignment, the author will adopt the triangulation approach in calculating the Equity Cost of Capital (ECC) as discussed on WebEx sessions.

2.2. Weighted Average Cost of Capital

Data Source: Tesco Annual Report, 2015

After inputting the above data in the spreadsheet provided for the course. I arrived at the below result for the WACC = (1-0.17%) x (6.30%) + 0.17% x 3% x (1+20%) = 16%.

Tesco\'s weighted average cost of capital is 6.29% and return on invested capital is 6.30%. This means Tesco is earning or will be earning returns that do not match up to its cost of capital which may affect its value in the future.

One of the limitations with the WACC is the accuracy of the result. This is because an assumption is used based on past data especially with the market risk premium. It could have been even more difficult to ascertain the Beta if Tesco was not a traded company. Again, if Tesco has acquired another firm then its market risk may increase as well as its default risk. This will cause an adjustment in the WACC result.

Finally, WACC is a forward looking projection and the estimations are based on expected returns and not on historical returns. This is why market value is considered for equity calculation and not the book value. Also WACC fluctuates with capital structure. Since Rd is frequently lower than Re, meaning the higher the debt level, the lower the WACC. This fairly clarifies why firms generally prefer issuing debt initially before raising more equity (Chartered Banker MBA, 2015, pg.35-37).

2.3. The Market Implied Cost of Capital (MICC)

The logic behind this method is very simple and is based on equity valuation from investors expected dividends on the going concern of Tesco (Burke, 2015). I will use dividend valuation model with the below input from Tesco's 2015 Financial Report.

The current share price is different from the model estimate. To correct this I used the What-if Analysis (Go seek function in Excel) to set the model price of 150.46 to the current share price of 163 by changing the cost of equity capital which has caused implied growth to be negative as shown below. This could be a signal that the Tesco's equity is undervalued given its long-term projections.

Data Source: (www.swissqoute.ch, www.tescoplc.com Tesco's Annual Report, 2015)

The cost of equity capital implied by a 163 share price is 6.30% and using a subjective rate of dividend growth of 9.50%. The greater the dividend the lower the rate of future growth and vice-versa. Table 1 in appendices provides us with the full information on items used for the adjustment which is at the disposal of interested stakeholders such as Financial Analysts for Tesco's financial performance analysis.  

The Earnings Growth which is the measure of year-on-year earnings per share (EPS) growth from the prior fiscal year, expressed as a percentage found on ft.com was +40.6 % and on money.cnn.com was 24.60%. These was based on Analysts estimates and projections. The Dividend Growth Estimate of 1% is somehow unreliable but does not affect the final result that much when there is a change in the estimate with the understanding that trade-off between future growth and current dividend is considered in the model. And even with Tesco, there is no change in the dividend payment for the years 2013 and 2014 (Ryan, 2013). The MICC hypothesis implies Tesco is going to continue in operation in the unforeseeable future and also, with the assumption that its equity rate will remain constant, therefore a fixed rate of 1% has been calculated to help forecast all future dividend payments.

2.4. Capital Asset Pricing Model (CAPM)

The CAPM is a model that identifies the relationship between risk and expected return of an investment. This model is used to price risky securities. The idea behind the CAPM is for investors to be rewarded on time value (risk-free rate (rf)) for money and the associated risk. This is estimated by taking a risk measure (beta) that matches the returns of the asset to the market over a period of time and to the market premium (Rm-rf). Since investors' risk and return expectations are based on a given period and the required rate of return determined by market risk exposure, we can therefore use three different rates to help us determine the risk-free rate (Chartered Banker MBA, 2015, pg. 18; Ryan 2015, p10).

 1 month T-bills 0.37% (20-May-2016)

 UK Government benchmark Bond Yield 1.46% for 10 years (20-May-2016)

 Tesco PLC Weighted Average long-term debt maturity for 5years is +5.000% (20-May-2016). Therefore it is good to use a risk-free rate UK Government benchmark of 5years which is 0.90% (20-May-2016). For simplicity in the calculation, we can consider the following assumptions that;

 All investors are risk-averse, utility-maximizers and have sensitive characters.

 There are no transaction cost and taxation in the market.

 All investors anticipate the same holding period.

 All investors have equal expectations on the market.

 All investors are extremely detachable and are price takers.

The formula is: Cost of equity = rf + βa x (rm – rf)

Where: rf = Risk-free Rate, βa = Beta of the security and rm = Expected Market Return

Here, a risk-free asset has no default risk and a good benchmark will be the yield on a default-free UK government debt instrument (uk.yahoofinance.com). Beta (β) here is the sensitivity of the expected extra returns on asset against projected extra market returns such as the relationship between Tesco's stock and a given market (Burke 2015). Historical data is normally used in β estimation, but in finance we know that past performance of Tesco is distinct from future performance and therefore using a historical data may not reflect future β of Tesco. Again, there may be an error in β estimation if ordinary least square regression is used (Burke, 2015). Using the OLS estimator, I got 0.51 β.

Now, the expected market risk premium is that which Tesco investors request for their opportunity cost in investing in market portfolio comparative to the risk free rate. The historical equity risk premium approach will allow as to gather past data to assist in finding the average rate of return in the UK.

 This is based on the theory that the realised equity risk premium detected over a longer period is a good gauge for the expected equity risk premium. For this purpose, I have employed an 8% UK average rate of return as Tesco's market risk premium. So CAPM: Cost of Equity = 1.46% + 0.51 x (8% - 1.46) = 12.9%. Investors to discount their expected returns on Tesco's current share value will use the 12.9% Cost of Equity. Most publically traded companies employ the CAPM in estimating Cost of Equity as this allows them to consider systematic risk even with non-traded companies. Burke, (2015) argues that CAPM as an estimate for Cost of Equity is debatable as there is difficulty in defining and measuring the market portfolio and if the wrong market index is used, then the final estimate will be affected. Again, long-run average returns are linked to Beta even though low Beta stocks can earn higher rates of return than projected by the CAPM model.

Risk Free Rate Estimate

   

     Source: www.FT.com

The CAPM assumes that the equity risk premium is derived comparative to a single period rate of return on holding a completely risk free asset. With two choices, we can either use the shortest dated Treasury Bill rate or a long dated Treasury Bond (10-year). The issue will be for the former its supposed volatility, while the issue with the latter is that the market risk is captured by the beta estimate. So we will use both and see what the difference is. Therefore, the T-Bill = 0.37%, T-Bond (10year) = 1.46%. The equity risk premium will be different depending on which rate we use.

2.4.1. Forward Equity Risk Premium

     Beta Estimate

The obstacle with the CAPM is that it measures the return over a definite period of time and as such it is uncertain to which extent it can be functional to the future periods, therefore using it in line with other models is recommendable.

2.5. Market derived Capital Asset Pricing Model (MCPM)

The MCPM in principle relies on either current data or future data with two assumptions;

 Equity investors will demand at minimum the expected rate of return on holding Tesco's debt.

 Equity investors will demand an additional rate of return over the corporate bond yield or its equivalent for compensation for taking on additional risk.

Estimation of Forward Stock Price = 2.92% - 10.04% = -7.12%

PTTM = 163 x (1-0.0712)2.125 = 139.32

Volatility of Equity (from the Volatility Estimator) = 7.3%

Put Value / Current share price = 0.28%. When annualized (2.03) becomes 0.14%, representing the premium over Tesco's corporate debt rate required by the equity holders. Finally, return on equity capital is calculated as the premium 0.14% + the rate of return of corporate debt 3% = 3.14 %. This is investors' rate of returns to be insured against falling below that of Tesco bondholders.

 So Tesco's Equity Cost of Capital after using the three methods (MICC, CAPM and MCPM) and taking an average is 9.3%. This is reasonable but not perfect considering the possible errors and assumptions in each of the method.

3. A Financial Analysis of Tesco

3.1. Specification of the Purpose of the Analysis

The purpose of this analysis is to assist interested stakeholders to make sound decisions on investments, objectives and overall strategies with regards to the financial analysis. The data presented in this report even though is past may assist stakeholders to distinguish the operational strengths and weaknesses of Tesco as well as its financial soundness.

3.2. The Interested Stakeholders of the Analysis Report and their likely Decisions

For the purpose of this assignment, I will consider three principal ‘'clients'' of Tesco's analysis; Management of Tesco will need the analysis report to ascertain the financial performance and position at a given period, as well as making strategic and operational business decisions for Tesco's sustainability.

Also, shareholders will use the report to identify and make decisions on whether to continue investing in the business or not. Comparing key ratios and their meaning will assist investors to estimate their expected returns and the risk level they can absorb and to decide whether to buy, sell or hold onto their shares. The report will aid investors to perform specific due diligence on Tesco (CBMBA, 2015, page 4).

3.3. A strategic Review of Tesco

3.4. Tesco Business Strategy

The company is successful by focusing and identifying customers as its top priority and making sure the right value is given to them. Tesco's aim is to recoup total focus on serving customers. This Tesco has done by reshaping its business into three operational headings:

 Listening to, understanding and reaching out to customers for value creation in offer.

 Working with farmers and suppliers to make great products, and to deliver value to customers.

 Working through diverse channels to reach customers with the needed products in a convenient manner.

This operational strategy is to ensure all-inclusive setup for efficiency and for value creation for customers. Tesco believe that reshaping these three areas coupled with its internal know-hows, scope, understanding and skills will exceptionally place Tesco in a position to deliver the best offer available and to earn

customers' loyalty, which will then create sustainable value for its shareholders (Tesco Strategic Report, 2015).

Figure 1: Tesco Operating Strategy

Source: Author/ Tesco Strategic Report, 2015

3.5. Tesco Core Competencies and Value Drivers

Tesco's core competencies is providing value and quality service to customers through strong channels which I see as being valuable for cost efficiency, rare for competitive advantage and inimitable for competitors to duplicate and non-substitutable, as Tesco will lose customers to substitute products and services if competitors come with substitutes. If this happens, prices will equal the discounted future costs, causing zero economic profits. (Cees, Kleinknecht, Ortt & Verburg 2008. Pg. 43&227; Johnson, Whittington & Scholes, 2011. Pg. 55&58).

One of Tesco's core capabilities is its customer focused strategy. By putting its customers on top priority and delivering to their needs and expectations has earned Tesco their loyalty. Programs such as ‘'Click & Collect'' points of sales across UK and the ‘'Clubcard'' reward system has allow Tesco to access the needed information on customers and strategized ways to serve them better. Tesco supply system is well designed in linking existing shops with its online platform ‘'Tesco.com''. Even though Tesco competitors are also online, the design of good user interface which allow customers to personalize online shopping experience has retain its customers. This has helped Tesco to improve its performance on different markets.

Again, Tesco has built itself a brand that has given it a competitive edge against its rivals which focuses on diverse market segmentations which has allow the company to have greater market share in the retail business. Finally, what I have observed with Tesco is that it's not afraid of change and therefore it's always adopting to innovation making it stand the test of time.

‘'Tesco Values'' was introduced a decade ago and have become a vital part of its culture, sustaining the company's growth and success. This ensure that every person at Tesco recognizes what is important and how the company works together as a team and how customers are at the centre of what they do.

Tesco value creation drivers are;

 Strategically transferring its core capabilities in retailing to new ventures

 Hiring of local managers and supporting with operational experts from the UK

 The ability to partner with other businesses and foreign markets

 Tesco workforce is knowledgeable in their fields

 Focusing on markets with good growth potential but lacking strong indigenous contenders.

3.6. Market and Economic Context

The economic environment continue to be a huge challenge in all Tesco markets and now the economic impact of ‘Brexit'. Even though improvements has began, consumers spending is yet to surge. Tesco UK uses its ‘'dunnhumby'' to track British consumers view on the economy and their individual situations. Tesco latest quarterly Consumer Today Report (CTR) identified that even though consumers are hopeful about the vigorousness of the UK economy, they are yet to experience it in their pockets. With this insight Tesco is able to support customers with their budgets by offering them value for money across all shops. In Central Europe, employment levels and consumer confidence has started to rise after a stretched period of economic stress, low levels and real income are starting to benefit from lower inflation, but household spending is yet to increase considerably.

In Asia, even though some economies are quickly growing, some were impacted by the recession in 2013-2014 which saw consumers stressed with huge debts such as Thailand. Furthermore, consumers' confidence was affected by Thai political unrest during 2014. In South Korea even though consumer confidence is high, household debt reached a record level. Inflation in Malaysia has affected consumer confidence coupled with low wage growth and proposed sales tax by the government. Population wise, Tesco has been affected.

Ageing and household size are falling across various markets. For example, in Asia, 50% of South Korean households are either one or two people, same in Thailand. This is due to rapid urbanization especially among the youth. This has led to preference in convenience shopping. All these factors and demand for agricultural products pose a risk to global food security and calls for the need of developing viable supply chains (The World Bank, 2015).

3.7. Strategic issues of Tesco with SWOT Analysis

Strengths: Tesco brand is very strong in the global arena, with the identity as a retail company that offers customers value for money, convenience, choices in products, and locally-sensitive management (Brand Finance, 2014; Wood and McCarthy, 2014). Tesco has taking advantage of innovation in its operations and as such the strengthening of its online business and the creation of medium shops such as Tesco Metro and Tesco Express in local communities to customers' convenience. Other Tesco strengths include the ability to enter emerging markets and the recruitment of local workforce. Buying in bulk has also allow Tesco to enjoy economies of scale allowing Tesco to lower prices coupled with its loyalty programs to attract customers and to compete with rivals.

Weaknesses: Tesco's expansion into different business lines and mostly different loyalty programs has expose the company to some weaknesses. For example, the companies profit was affected by bad debts from credit cards and customers claims on insurance combined with introduction of products with less experience such as Tesco's smartphones and tablets competing with strong brands as Samsung and Apple. Huge investment to maintain web services and store renovations has averted funds from implementing strategies that will reduce price which has caused reduction in sales and a loss in profit of over £6.4billion for 2014 -2015 operating year.

Opportunities: The external environment where Tesco operates has provided many opportunities such as venturing into different business lines, for example, its 80% investment in Blinkbox and the induction of its own brand smart phones and tablets. Tesco has also taking advantage of technology in given customers flexibility through its online shopping experience. Tesco could also benefit from Brexit.  

Threats: Tesco's position as the top retail company in the UK is a target for competitors such as Asda, Morrison's, Sainsbury's, Lidl, etc. which could lower its UK market share. Also unpredictable events in overseas market such as recessions, government policies and political unrest could humper its foreign revenue. Also, UK exist from the European Union may affect Tesco's foreign market operations.

3.8. Financial issues implied by the Analysis

Tesco's trading profit has reduced by £1.4billion reflecting the challenges such as tense competition faced in both UK and its overseas markets. Can Tesco position itself to meet customers who are had to impress as they want simple and stable and low prices with unlimited choices and exceptional service as its revenue stream has been affect?  

4. Accounting Analysis

Tesco's 2015 financial report is detailed-oriented, explaining figures appropriately based on International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Practice (GAAP) UK with adjustments to help round figures and for better year-to-year comparisons. Management voice can well be heard in their views and progress of Tesco. Deloitte, the new appointed External Auditors of the company has also issued an unqualified opinion. Tesco's fiscal year ended 28 February 2015 for the UK and Republic of Ireland. Adjustments such as EBITDA, Net Income and EBIT are considered for possible accounting errors as the financial report is a consolidation of the Group's global operations with different accounting reporting methods.

 Tesco's financial statements were prepared on the historical cost basis, statutory loss before tax was £(6.4)billion, after charging one-off items of £(7.0)billion. Of these one-off items, £(0.6)billion resulted in a direct cash outflow, with the outstanding amounts being non-cash adjustments to balance sheet carrying values. The report has also provided greater clarity on commercial income and the valuation and ownership of Tesco's property with footnote for additional information.

4.1. PERL Framework Financial Analysis on Tesco

4.1.1. Performance

The PERL (Performance, Efficiency, Risk and Liquidity) framework is very useful for two reasons: It gives us the idea and picture of how Tesco's financial ratios are linked and offers a structure that is consistent with the above SWOT analysis.

    Source: http://financials.morningstar.com/ratios/r.html?t=TSCDY

The above ratios indicates a declining performance for Tesco in 2015. Margins which measures the return of profit on all invested capital has declined significantly and may be as a result of tense competition and other supply chain management issues. ROCE of -23.54% is indicating that shareholders are paying heavily for Tesco's investment in current assets and that there has been less efficient use of capital in 2015 and as such not generating shareholder value. Investors may end up favouring rivals with stable and rising ROCE numbers than Tesco with volatile ROCE over the years. -52.70% of ROE is an indication that there has been a loss in profit with the money shareholders contributed. -11.78% NIM is also telling us that interest expenses were greater than the amount of returns Tesco generated by investments. ROTA has not been effective as company used to generate earnings before paying contractual obligations (Taxes). All this tells us the challenge facing Tesco both in UK and its international markets.

4.1.2. Efficiency

Cost Efficiency Ratio (CER): The analysis suggest that Tesco has been less efficient in costs consumption in 2015 even though revenue grew by 2%.

Tesco's efficiency at converting its non-current assets to revenue is down by £2,336million from the previous year. The £1 of new investment in non-current assets in 2015 yield a marginal increase of £o.55. I anticipate marketing cost, labour and others to be significant drivers of revenue.

The above ratios indicate that Tesco from receiving goods from suppliers until customers make payment takes approximately 68 days. While Tesco pays suppliers on average 56 days, it has to finance from its own resources 12 days until goods are sold and payments received. The same as in 2014. This is an over-trading issue affecting Tesco's effort in expanding its revenue.

4.1.3. Risk

The 97% show high fixed costs in Tesco's cost structure which makes the company more vulnerable in profitability fluctuations. The 97% and 106% for 2015 and 2014 respectively implies that any variation in turnover would impact upon Tesco's operating profit. The question is, does Tesco has internal cost flexibility? The increase in gearing ratio is also due to lower net assets. This is largely as a result of Tesco's actions to impair asset values in Europe and goodwill in China.

The Cost of Operational Gearing has been plotted using MS Excel with Tesco's 5-year Revenue and EBITDA, which indicates that for the 5 years on average (1-0.0878) or 91.22% of revenue is variable cost while the balance of the costs is fixed. The above estimates indicates that the fraction of fixed cost is marginal suggesting that changes in EBITDA are not in line with Tesco's revenue. A concern that must be addressed by management. This is due to the fact that Tesco is growing and is increasing its expenditure on non-current assets and human assets whiles revenue is decreasing.

4.1.4. Liquidity

Tesco's current ratios are below 1, showing difficulties in meeting current liabilities obligations as they come due. The quick ratios are firm, showing Tesco's low liquidity level. This is due to high non-current assets and inventory cost.

Tesco has decreased its liquidity from 69 days to 63 days with the cash they have at hand. We cannot tell if this is good or not considering the substantial instabilities in seasonal effects. Also Tesco may decide how it want to keep its cash, whether they want to keep it all the time or to invest for returns, this will be a corporate decision.

Tesco's operating cash flow to maturing obligation has declined significantly from 74% in 2014 to 19% in 2015.  15% and above is for successful firms, while –5% and below is for  failing firms, within five years of eventual collapse.  Tesco is in the range and can be considered as an intermediary value for the company.

The investment coverage ratio indicate Tesco's cash from operating activities is inadequate to cover its investments. This means Tesco will be seeking additional funding from other sources which may increase its risk level and may not appeal to potential investors. Tesco must therefore strategize its activities so it can reduce its future capital expenditure for viability.

4.2. Summary and Conclusion of the PERL Analysis

It is clear from the above analysis that Tesco is stifling in generating profit coupled with heavy investment in non-current assets and efficiency improvement. These may be as a result of Tesco\'s troubles from accounting scandal that has obligated changes in its top management, a sinking share price, decreasing sales and loss of consumer confidence as consumers turn to discount rivals such as Lidl and Aldi. Nevertheless, Tesco has put in place a road map to address the key issues by rebuilding trust with shareholders and stakeholders, as well as to win consumers' confidence in Tesco's brand.

To the clients of this analysis, especially shareholders, they should hold their shares and not sell them, but must not extend their risk by buying more. For lenders, the loans already given should be enough and must put measures in place to make sure it's been repaid even if it delays but no further loans must be given to Tesco, at least for now to limit any insolvency risk. The lenders may review the loan terms and the covenants.

5. Valuation Analysis

5.1. A fair value equity valuation

For this part, I will used Dividend Valuation Model to estimate a fair value of Tesco's Equity. This is because Tesco is supposed to pay out dividend every year, all things being equal. I will therefore adopt three assumptions from the study guides provided for this assignment;

 That Tesco is a going concern company.

 Receiving constant rate of return in future periods.

 Chang in future dividends due to change in certain pattern.

I have used past Tesco's 10-year revenue and plotted with Excel and Best-fit line, using both linear and exponential trends.

Market (Regional) Revenue Forecast (excluding IFRIC 13)

Tesco's 2015 Annual Report provided us with an overview of sales per region whiles the real Gross Domestic Product (GDP) growth for each region was source from International Money Fund (IMF) and World Bank databases and came out with the below table.

Sources: Tesco Annual Report, 2014/2015, World Bank & International Monetary Fund)

Firm Specific Forecast

     Source: http://www.tescoplc.com/index.asp?pageid=31

Forecasting revenue based on firm specific factors, I have considered certain constructs based on Ten Multi Attribute Preference System (FATMAP), I have selected 10 important constructs for Tesco which I believe drives its revenue growth.

5.2. Ten Multi Attribute Preference System (FATMAP) for Tesco

Rating the Constructs

The constructs is then rated from very low to very high as per their alleged significant in revenue generation.

Significant of the Constructs

I have rated Innovation and R&D as the most significant constructs as I believe this pushes the selling of Tesco's products and distinguishes it from rivals. Customer-Service, Branding, Technology Management, Marketing and Pricing allows Tesco to reach its customer base and sell its products. Next are Supply Chain and Productivity which increases the potential of revenue growth by making sure products are available for customers to choose from having greater market share or reaching the greater customer base.

Voting the Constructs

Voting considerations

I inputted the actual revenue for the last 5 years which are in the yellow boxes and voted the constructs for those years. For 2011 I considered pricing, Marketing and R&D as the most significant in terms of revenue drive followed by Innovation and Productivity. From 2012 to 2015 I believe innovation, R&D, Pricing, Branding and Customer-Service were at the top of the list as Tesco needed to differentiate itself in the market. I believe innovation, Branding and Customer-Service will remain significant in the coming years to drive revenue especially with UK existing from the EU much is needed for Tesco to expand its local market share.  

5.3. Revenue Analysis & Forecasting

A B C D E F

Retrodicting and Adjustment of Parameters:

Based on the past revenue and the voting I provided the model retrodicts the past revenue in the Forecast Revenue/Earnings column for the first 4 years which shows decline compare to the actual revenue. The variances show under-voting in all years except in 2012. This shows bias in the voting and needs a bit of flexibility. Tesco's revenue projection is based on expansion plans per the below;

 Tesco Lotus in Thailand to open 65 new stores by the end of 2016. Plans to build 49 sites and agreed sale of 14 sites for £250 million.

 The new Tesco Brand Guarantee has enhanced the UK service about 9000 customer facing roles, as well as major investment in price.

 Reduction its product base to 18% and lower average weekly cost of shop by 3% for efficiency and value for money.

 2000 new products have been introduced onto the market.

 60 unprofitable stores closed.

 Private label restructure has been launched on seven new Farms brands.

 Reduction in debt by £6.2billion

 Regaining ownership of 70 stores and two distribution centres, improving its freeholds ratio by 6% points to 47% in the UK and Ireland and reduction in Tesco\'s exposure to rent increases.

Combined Revenue Forecast

Beta = 1.03% x 100 = 0.0103%

0.0103 x Market + (1-0.0103) x Firm

The issue here now is the type of weights to assign to the Tesco's different line of revenues. Therefore I have used 1.03% from Assignment 1, for Tesco's past returns can best be explained by the market variations rather than its internal specific variations. So I have weighted on average the market and firm specific forecasts by 1.03% and have calculated trend forecast using 0.5% as a 50/50 weights for near accuracy.

5-Year Tesco Valuation Model

Present Value 2.43

Sources: http://www.4-traders.com/TESCO-PLC-4000540/financials/

   http://x-fin.com/stocks/usa/TESO

TV = FCF +1 / (r – g)

FCF =Free cash flow, r= discount rate (cost of equity or capital), g = expected growth

5.4. Main Drivers of the Valuation Model

 Tesco's historical financial data, market growth demonstrated through GDP growth, has been the main drivers for analysis in assignment 2 of this paper, applying to Tesco's different markets and specific growth. Tesco has its way of calculating financial figures giving more details with the assumptions of continuing updates on projected market trends, geographical growth plans, etc.

 Depreciation and amortization figure has been considered as fixed % of 2015 revenue (62,284/38,135=1.63%) for easy of calculations as Tesco will have much better forecast.

 For interest expense, I used 35% which was the rate for 2015 on total borrowing and applied it on 2015 borrowings. There is a possible error here as I have not captured all the borrowings for 2015.

 I had a hard time coming up with the Financial Income and therefore since Tesco has a huge size of financial incomes each year. I therefore employed a 5-year average historical data as the basis. This is a driver that will cause an error in the estimation.

 Since Tesco is taxable in a number of jurisdictions around the world, its effective tax rate, which is income tax expense as a percentage of pre-tax earnings, fluctuates from year-to-year based on the level of profits earned in these jurisdictions and the tax rates applicable to such profits. Therefore I used the highest tax rate of 26.4% which is the rate charged Tesco in Canada.

 Tesco had a net Income loss in 2015 and therefore would definitely not pay out dividends. I therefore used an estimate for EPS for the purpose of the assignment. Which is a possible driver for error.

 It is very difficult to project the company's financial statements showing how they would develop over a longer period of time. The confidence level of financial statement projection diminishes exponentially. Also, macro-economic conditions affecting the business and the country may change structurally and therefore, I simplified and use certain average assumptions to find the value of the firm beyond the forecast period (“Terminal Value”).

5.5. WACC Sensitivity

From the above we could conclude that the WACC is very sensitive to cost of Equity and marginally sensitive to cost of debt and the volatility on equity, considering Cost of Debt (-20% and +20%). So the movements in the three methods (CAPM, MCPM and MICC) can help us to conclude that the likely error range for the WACC calculated is 20%.

6. Estimate of the Volatility of Tesco's Assets

     I have used The Merton's Structural Debt Model to estimate Tesco's volatility, which shows that Tesco can be in business for the next 12 months.

7. Tesco's Default Risk and Potential Credit Rating

Beaver's Ratio

This ratio gives an indication of imminent failure with over 70% of firms which show values less than 0.15 failing within five years. This means Tesco is heading towards failure with 0.14% in 2015 and its ability to meet its obligations in the form of outstanding debt is in doubt.

Z Score Analysis

Z-score =1.2 (-0.18) + 1.4 (0.04) + 3.3 (-0.13) + 0.6 (0.44) + 1.0 (1.40) = 1.075%. The Z-score of 1.075% as calculated in appendix 11 denotes that Tesco is in distress and may not be able to meet its debt obligations. The model forecasts distress zone when Z<1.81 and < 2.99 as safe zone (CBMBA, Financial Analysis: Study Guide 2, p.32).

8. Potential Credit Rating

Moody\'s Investors Service in January, 2015 downgraded Tesco to Ba1 from Baa3 the senior unsecured long-term ratings of Tesco Plc and its guaranteed subsidiaries. Concurrently, Moody\'s has downgraded to Not Prime from Prime-3 (P-3) the short-term ratings of Tesco and its subsidiaries and has assigned a corporate family rating (CFR) of Ba1 and a probability of default rating (PDR) of Ba1-PD. Moody was with the view that the operational changes in the UK grocery retail market will remain a challenge to Tesco's operating performance. Tesco's corporate bonds was also rated \'junk\' rather than \'investment grade\' status, by Standard & Poor\'s and Moody\'s. This was due to Tesco's falling sales and an accounting scandal in 2014 which affected its share price. This means fund managers, pension funds, banks and other institutions holding Tesco's bonds may have to sell as they no longer qualify as ‘'investment grade''. The company may also have to offer higher rates of interest or coupons on future bonds so it can attract investors (Moody.com, 2015 ; The Guardian, 2015).

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