ACC336 Financial Analysis: Capital Structure & Finance at Tesco PLC

This report provides an analysis of capital structure and sources of finance, focusing on Tesco PLC, a company listed on the FTSE 350 index. It discusses the concept of limited liability shareholders, explores the components of Tesco PLC's capital structure including equity share capital (share capital, share premium, reserves, and retained earnings) and non-current liabilities (borrowings and derivative financial instruments), and evaluates the efficiency of Tesco's capital structure using the debt-to-equity ratio. The report also explains why ordinary shareholders are considered ultimate business risk-takers due to factors like uncertain dividend payments and their position in liquidation proceedings. Furthermore, it briefly touches on why debt finance typically has a lower required return than equity and why large public companies are better positioned to raise share capital than limited companies.

Capital Structure and Sources of Finance
1

Contents
Introduction...........................................................................................................................................3
A. Limited liability shareholders............................................................................................................4
B. Analysis of capital structure in Tesco PLC..........................................................................................5
C. Why Ordinary shareholders are known as ultimate business risk takers..........................................8
D. Why does debt finance usually has a lower level of required return than equity?.........................10
E. Why large public companies are in a better position to raise share capital than limited companies?
.............................................................................................................................................................11
Conclusion...........................................................................................................................................12
References...........................................................................................................................................13
2

Introduction
Capital structure is one of the most essential factors that is considered by any business organization
before initiating any type of project in the organization. For example, if the management of the
company is seeking to expand is business operations than first thought that will arise in the minds of
managers and top management of the company is the source of funding (Scarborough, 2016). Top
management of the company will evaluate to which source of finance will be profitable and cost-
efficient for the organization. In addition to that, they will also evaluate which source of finance will
be helpful in maintaining an effective and efficient capital structure. Generally, business organization
finances its capital with the help of two components of capital i.e. equity component and debt
component. It is very important for a business organization to maintain an effective balance
between debt capital and equity capital. Excess of both of these capital components can result in a
negative impact on overall business operations. For example excess of equity share capital can result
in the liquidation of ownership whereas an excess of debt capital will result in excessive interest
payments by the company (Burns and Dewhurst, 2016). The main objective of this report is to
analyse capital structure and source of financing in a particular business organization operating at a
large scale level. For this purpose, Tesco PLC has been selected which is listed in the FTSE 350 index
of London Stock Exchange.
3

A. Limited liability shareholders
True owners in a business organization are considered to be equity shareholders that have
purchased equity shares distributed by the management of the company actor any period of time. It
is considered that management of the company is only acting as a representative of equity
shareholders and they have to act in the best interest of the company as well as shareholders. One
of the primary objectives of any business organization is to maximize the wealth of investors which
shows that management of the companies operating in the best interest of its shareholders ( Jelsma
and Nollkamper, 2017).
In business structures like partnership form and proprietorship business, management of the
company and owners of the company are the same. One of the primary reasons that investors and
shareholders prefer to invest in the corporate organization is due to its limited liability concept.
According to this concept liability of shareholders in corporate business, the organization is limited
to some extent. According to this concept, shareholders will not be held liable personally for any
kind of activities undertaken by the business organization (Haldane, 2015). A business organization is
considered to have separate legal identity and actions of business organization cannot be depicted
as an act of the shareholder.
On the other hand in business structures like proprietorship and partnership, any action undertaken
by the Business entity is considered to be action taken by its partners or owners. Any kind of legal
case initiated against corporate organization will not be considered as a legal case against its
shareholders due to separate legal entity concept. It can be said that according to the limited liability
concept management of the company can ask for unpaid call money from its shareholders in case of
liquidation or any other liability arising on the company (Yamey, 2014). According to the limited
liability concept, shareholders will not be held personally liable for any kind of liability.
4

B. Analysis of capital structure in Tesco PLC.
As it is already discussed that it is very important for the business organization to have an effective
and efficient balance between equity and debt capital in the capital structure. This section of the
report will discuss components of debt and equity in the capital structure of Tesco PLC. In addition to
that various other aspects of capital structure will also be discussed.
Equity share capital
The equity share capital of this organization include the share capital, share premium, reserves and
retained earnings. All of these components are considered as part of equity share capital as these
are distributed by the management of the company to equity shareholders of the organization.
Equity share capital is directly collected from equity shareholders in exchange for equity sharing in
the organization. In addition to that, the security premium is considered as excess money charged by
the business organization from its shareholders which can be defined as the difference between the
issue price and the face value of the share (Goetsch and Davis, 2014). For example, if the
management of the company has issued share for $20 per share but the face value of the share is
only $10 per share, then $10 per share would be considered as share premium collected by the
organization due to excess demand of share in the market. Retained earnings and reserves are also
considered as a part of equity share capital because they are located from the profit generated by
the organization and kept aside for specific purposes.
On the basis of categorization provided to by the management of the company in the balance sheet,
it can be said that management has divided to the total equity share into two categories i.e. equity
share attributable to controlling shareholders and equity attributable to non-controlling
shareholders (Winnubst, 2017).
At the starting of the financial year, 2018 management of the company had already issued
8,174,932,553 shares to its shareholders. During the financial year, some of the shareholders have
exercised their power of right share which resulted in a total increase of 5,184,066 shares. In
addition to that of management has also awarded 12,000,000 bonus shares during the financial year
under consideration to existing shareholders. Therefore a total number of shares at the end of the
financial year 2018 was 8,192,116,619 (Tesco Plc., 2018). According to note 28 in notes to financial
statements ending 2018, all of these shares are ordinary shares of 5 pence each. According to this
calculation total equity share capital at the end of the financial year, 2018 is £400 million. At the end
of 2018, there was only one category of shares issued by management i.e. equity shares.
5

Management of the organization has categorized reserves maintained by the organization into two
categories i.e. retained earnings and all the other reserves. Specific categorization has not been
provided but it can be said that retained earnings are free reserves that can be used by management
for any purpose (Ashkenas et.al, 2015). On the other hand, other reserves are capitalized reserves
that will be used only for the purpose decided by the management of the company. Total value of
other reserves and retained earnings at the end of 2018 are $735 million and $4228 million
respectively.
Non-current liabilities
Total non-current liabilities at the end of the financial year 2018 was £4120 million. This non-current
liability consists of borrowings and derivative financial instruments that are not payable by the
organization in the next 12 months i.e. till the end of the financial year 2019. This capital can be
considered as debt capital of the organization as management has financed capital assets with the
help of borrowings and derivative financial instruments (Bustinza et.al, 2015).
The efficiency of capital structure- as it is already discussed that it is important to have an effective
balance between capital and that component of the business organization's capital structure. This
capital structure can be evaluated with the help of debt to equity ratio at the end of a financial year.
This is the ratio that helps in establishing a relationship between debt capital and equity capital of
the organization. Generally, it is considered that the debt capital should be slightly higher than
equity capital in the organization i.e. debt to equity ratio should be between 1 and 1.5 for large scale
business organization such as Tesco PLC. (Lee, Kozlenkova and Palmatier, 2015).
Debt to equity ratio of this organization was 0.47 in the year 2017 and has decreased to 0.34 at the
end of the year 2018. It clearly shows that Tesco PLC is an equity-centric business organization and
the majority of finances over the period of time are acquired by this organization through raising
equity shares in the market. This practice of capital financing is very common in large scale
organizations as it is very easy for the listed companies to raise funds through equity sources. On an
overall evaluation, it can be said that management of the company should focus on raising capital
through debt sourced in the future for maintaining the effective capital structure (Pettigrew, 2014).
This type of capital structure can be very harmful for the business organization from a long term
perspective. It is a common nature of equity shareholders to expect higher returns on their
investment over the period of time. Therefore if the management of the company is paying 20 pence
dividend on every share in a particular accounting period then shareholders will be expected 25
pence per share dividend in the next financial year and so on. Therefore in this scenario, it can be
6

said that overall cost of equity shares will increase significantly over the period of time whereas cost
associated with the debt financing will remain to seem as fixed the rate of interest is required to be
paid by management (Van der Voet, 2014). It is suggested that management of Tesco PLC should
conduct buyback of shares and raise capital through debt financing to maintain a debt to equity ratio
of 1 to 1.5.
7

C. Why Ordinary shareholders are known as ultimate business risk takers
Following are the factors that will help in understanding the manner in which ordinary shareholders
are considered as ultimate business risk takers in the market-
 First of all, it is not necessary that all business organizations will pay a return on the investment
made by equity shareholders through the purchase of ordinary shares. There is no compulsion
on the business organization to pay shareholders any kind of dividend or bonus share. Generally,
it is a business practice in business organizations to pay off dividend after retaining a significant
amount of profits for future growth and development in the organization. In addition to that
business, organizations are not legally bound to pay shareholders any kind of dividend or bonus
share irrespective of the amount of profit earned by the organization in a particular accounting
period (Fenghua et.al, 2014). Therefore it can be said that to equity shareholders are taking a
risk by investing in a security that might or might not provide a regular return on their
investment.
 According to the rules and regulations of Corporation Act, at the time of dissolution of a business
organization equity shareholders are not considered as secured creditors. It means that the
management of the company will be liable to pay equity shareholders only after payment is
made to all the secured and unsecured creditors in the balance sheet. Therefore it can be said
that the payment to equity shareholders at the time of liquidation of business is totally
dependent on the availability of funds after making payments to all the other creditors of the
business. Therefore ordinary shareholders can be considered as ultimate business risk takers as
they are aware of the fact that they might not be able to recover their principal amount of
investment in a business organization if the business fails to generate profits and goes into
liquidation (Hutchinson, Seamer and Chapple, 2015).
 Majority of equity shareholders invest through the market in a particular organization. Price in
the stock market of any particular organization is totally dependent on its demand and supply in
the market. If the financial position of an organization is higher than the demand for such an
organization it will automatically increase which will increase the price per share of the
organization. Therefore it can be said that the wealth of ordinary shareholders is totally
dependent on fluctuations in the market.
 There are various cases in the past where a particular event can have a very significant impact on
the overall market share of the company. For example discovery of financial frauds or
management frauds in the organization can result in a sudden decrease in the market price of
ordinary shares. In such cases, the demand for these shares decreases significantly whereas
8

supply increases as all investors want to sell such shares immediately (Wen et.al, 2014). In such
cases, it is identified that the majority of losses incurred to the ordinary shareholders in the
organization.
 Ordinary equity shareholders are also considered as ultimate risk takers because there is no
surety that these investors will be able to recover their initial investment from the business
organization. In any other kind of investment, investors are sure that they will be able to recover
the principal amount of investment if adequate returns on investment are not provided. There is
a legal obligation on debt financiers that they have to provide return and principal payments in
accordance with the contract entered into between investor and financier (Guiso, Sapienza and
Zingales, 2018). In the case of equity financing, there is no contract between the organization
and equity shareholders in relation to regular payment of returns and principal.
9

D. Why does debt finance usually has a lower level of required return than equity?
The required rate of return on debt finances is significantly lower as compared to equity finances
due to various reasons. One of the primary reason of availability of fewer returns on the death of
finances is that there is no risk associated with debt finances. Investors of debt finances will be paid
in accordance with the contract that is entered into between business organization and debtor of
the company. If the management of the company has issued 10% debentures in the market then the
business organization is legally bound to pay 10% interest on every debenture issued by the
organization. On the other hand, there is no certainty that payments in the form of dividend and
bonus shares will be paid to equity shareholders (Lev and Gu, 2016).
There is no contract in relation to payments between a business organization and equity financiers.
Return on equity investment is totally dependent on profits generated by the organization. The
overall return on an equity investment will be significantly higher as compared to that finances if
management is able to generate a significant amount of profit in a particular accounting period. The
difference in time period associated with equity shares and debt finance instruments is also one of
the primary factors that result in the difference between available returns ( Lim, Sensoy and
Weisbach, 2016). There is no specific time associated with the redemption of equity shares as
investors generally invest in equity share of the organization for a long period of time. On the other
hand investment in that finances is specifically for a limited period of time. Investors are sure that
they will receive the principal amount of investment after the time period discussed in the contract
is completed.
Another reason of availability of higher returns on equity finances is that the value of a principal
amount is dependent on demand and supply of shares in the market. It is not essential that the
value of investment made by the investor in equity shares of a business organization will remain the
same over the period of time. There is a possibility that the value of an investment will decrease
over the period of time due to the decrease in market value per share of the organization. This type
of fluctuations in the principal amount of investment does not change in case of death finances
(Chandra, 2016). If a particular investor has made an investment of ten thousand pounds in
particular debt instrument then search investor will receive 10000 pounds at the time of maturity
irrespective of the market condition.
10

E. Why large public companies are in a better position to raise share capital than limited companies?
After evaluation of a capital structure in Tesco PLC, it was concluded that the capital structure of this
organization is equity-centric. This type of capital structure can be identified in the majority of large-
scale organizations as it is very easy for such organizations are to raise share capital as compared to
other Limited companies. Following are the factors on the basis of which it can be said that it is easy
for large scale organization to raise share capital–
Availability of financial resources- Management of the organization has to spend a significant
amount of financial resources at the time of introducing public offerings in the stock market.
Financial resources available with large-scale organizations are significantly higher as compared to
middle or small Limited companies. These large scale organizations can spend these financial
resources on a regular basis but it is not possible for other organizations ( DeFusco et.al, 2015). In
addition to that marketing, expenses are also essential for informing investors about the public
offering introduced by any business organization which requires additional financial resources.
Popularity in the market- Popularity of business organization is also an important contributing factor
that makes the process of raising share capital for large-scale organizations easy as compared to
other organizations (Jordan, Miller and Dolvin, 2015). Investors will definitely choose to invest in the
share capital of large scale and popular organizations such as Walmart, Apple, Tesco, etc. as
compared to small organizations as they are aware of the product and services of such
organizations.
Availability of Returns- due to popularity in market overall profitability generated by large scale
organizations is significantly higher. Therefore it is very common for large-scale organizations to
provide higher returns on investment as compared to smaller organizations. In addition to that
large-scale organizations can provide you return in form of a dividend to equity shareholders in
adverse market situations due to availability of retained earnings (Ghosh and Mahanti, 2014).
11

Conclusion
On an overall evaluation, it can be concluded that effective and efficient capital structure and source
of Financing is very important from a long term perspective of business operations. The cost
structure of the organization is highly dependent on the cost associated with a source of financing. If
the cost of finances of a particular source of finance is very high then it will affect the overall
business operations irrespective of the fact that other sources of finances is cost-efficient. This
report has identified different aspects of the source of financing and capital structure with the
primary focus on Tesco PLC. It can be said that the capital structure of Tesco PLC is equity-centric
and there is a requirement of increasing debt component in the organization. This report has also
evaluated that returns provided on equity investment are higher due to the fact that risk associated
with such investment is higher than fixed interest investment.
12

References
Ashkenas, R., Ulrich, D., Jick, T. and Kerr, S., 2015. The boundaryless organization: Breaking the
chains of organizational structure. John Wiley & Sons.
Burns, P. and Dewhurst, J. eds., 2016. Small business and entrepreneurship. Macmillan International
Higher Education.
Bustinza, O.F., Bigdeli, A.Z., Baines, T. and Elliot, C., 2015. Servitization and competitive advantage:
the importance of organizational structure and value chain position. Research-Technology
Management, 58(5), pp.53-60.
Chandra, P., 2017. Investment analysis and portfolio management. McGraw-Hill Education.
DeFusco, R.A., McLeavey, D.W., Pinto, J.E., Anson, M.J. and Runkle, D.E., 2015. Quantitative
investment analysis. John Wiley & Sons.
Fenghua, W.E.N., Zhifang, H.E., Zhifeng, D.A.I. and Xiaoguang, Y., 2014. Characteristics of
Investors'risk Preference for Stock Markets. Economic Computation & Economic Cybernetics Studies
& Research, 48(3).
Ghosh, A. and Mahanti, A., 2014, June. Investment portfolio management: a review from 2009 to
2014. In Proceedings of the 10th Global Business and Social Science Research Conference (pp. 23-24).
Goetsch, D.L. and Davis, S.B., 2014. Quality management for organizational excellence. Upper Saddle
River, NJ: Pearson.
Guiso, L., Sapienza, P. and Zingales, L., 2018. Time varying risk aversion. Journal of Financial
Economics, 128(3), pp.403-421.
Haldane, A., 2015, May. Who owns a company? In Speech, University of Edinburgh Corporate
Finance Conference, May 22nd.
Hutchinson, M., Seamer, M. and Chapple, L.E., 2015. Institutional investors, risk/performance and
corporate governance. The International Journal of Accounting, 50(1), pp.31-52.
Jelsma, P.L. and Nollkamper, P.E., 2017. The limited liability company. LexisNexis.
Jordan, B.D., Miller, T.W. and Dolvin, S.D., 2015. Fundamentals of investments: valuation and
management. McGraw-Hill Education.
13

Lee, J.Y., Kozlenkova, I.V. and Palmatier, R.W., 2015. Structural marketing: Using organizational
structure to achieve marketing objectives. Journal of the Academy of Marketing Science, 43(1),
pp.73-99.
Lev, B. and Gu, F., 2016. The end of accounting and the path forward for investors and managers.
John Wiley & Sons.
Lim, J., Sensoy, B.A. and Weisbach, M.S., 2016. Indirect incentives of hedge fund managers. The
Journal of Finance, 71(2), pp.871-918.
Pettigrew, A.M., 2014. The politics of organizational decision-making. Routledge.
Scarborough, N.M., 2016. Essentials of entrepreneurship and small business management. Pearson.
Tesco Plc. 2018. Annual Report 2018. Retrievable at:
https://www.tescoplc.com/media/474793/tesco_ar_2018.pdf
Van der Voet, J., 2014. The effectiveness and specificity of change management in a public
organization: Transformational leadership and a bureaucratic organizational structure. European
Management Journal, 32(3), pp.373-382.
Wen, F., He, Z., Gong, X. and Liu, A., 2014. Investors’ risk preference characteristics based on
different reference point. Discrete Dynamics in Nature and Society, 2014.
Winnubst, J., 2017. Organizational structure, social support, and burnout. In Professional
burnout (pp. 151-162). Routledge.
Yamey, B.S., 2014. The Development of Company Accounting Conventions, by. In Evolution of
Corporate Financial Reporting (RLE Accounting) (pp. 243-252). Routledge.
14