Financial Planning of Sainsbury Supermarket - Coursework Example

Supervisor Financial planning and decision making (personal development reflective essay, 2008/2009 Foreign currency exposure-TheCase of Sainsbury Supermarket United Kingdom March, 2009 Table of Contents 1.0Introduction 1.1Overview of Sainsbury Supermarket 1.2 Impact of Foreign Exchange Exposure on Sainsbury Supermarket 1.2.1Ways through Which Sainsbury could manage its foreign exchange exposure 2.0Impact of Share Valuation on Sainsbury Supermarket 3.0 Impact of Capital investment appraisals tools on Sainsbury Supermarket 4.0 Conclusion and Recommendation 1.0Introduction Bodie et al (2002) state that the international economic environment might affect a firm’s export prospects, the price competition it faces from competitors, or the profits it makes on investments abroad. Although economies are linked to each other in a global macro economy, there exist considerable differences in the economic performance across countries. (Bodie et al, 2002). It is therefore necessary for an investment or security analyst to consider these differences before providing investment advice. According to the IMF World Economic Outlook (2008), the global economy remains on track for continued robust growth in 2008 and 2008 although only at a moderate rate than in 2007. The 2008 outlook also reports that downside risk to the outlook seems more threatening that at the time of the September 2007 outlook. This is because oil price declines since last august and generally benign global financial conditions have helped to limit spillovers from the corrections in the US housing market and to contain inflation pressures. (IMF World Economic Outlook, 2008). Thus, multinational companies must rethink their global strategies, in the phase of foreign exchange rate and falling price of oil. The present circumstances make them victims of foreign exchange risk and exposures. Against this background, the purpose of this paper is three fold. The study first of all is aimed at carrying out an analysis of the impact of foreign exchange exposure on a United Kingdom UK based retail company-Sainsbury Supermarket. In the second part of the paper, the paper analysis the impact of capital investment appraisal tools on the activities of Sainsbury group. In the third part of the paper the paper asses the impact of share valuation on Sainsbury group. The last section of the paper presents conclusion and a brief recommendation to the company’s management on how to go about getting the best from foreign currency exposures. 1.1 Brief Overview of Sainsbury Supermarket Like macroeconomic analysis the analysis of the industry is important because it enables the analysts to make abnormal profits arising from information asymmetry between the proper analyst and competitors who fail to carry out a proper analysis. Just as it is difficult for a firm to do well in a poor macroeconomic environment, so too is it difficult for a firm to perform well in a troubled industry. (Bodie et al, 2002). Similarly, as performance can vary across countries, so too does it vary across industries. (Bodie et al, 2002). According to the company, (2008) report, J Sainsbury plc is a United Kingdom-based food retailer with interests in financial services. The main activities of the company are in the groceries, related retailing and financial services. According to the corporate report, J Sainsbury plc consists of 504 supermarkets and 319 convenience stores and Sainsburys bank. Sainsburys Online is the Companys Internet-based home delivery shopping service, which operates from 97 stores. Bells Stores operates a chain of 54 convenience stores in north east England. Jacksons Stores operates a chain of 114 stores across Yorkshire and the North Midlands in the United Kingdom. Sainsburys Bank, owned by J Sainsbury plc and HBOS plc group, offers a range of products, including savings and loan products. The Companys businesses are organised into two operating divisions: 1.2 Impact of Foreign Exchange Exposure on Sainsbury Supermarket The degree to which a company is affected by currency fluctuations is referred to as foreign exchange exposure. (Shapiro, 2003). Foreign Exchange exposure can be divided into two main types-Accounting exposure and Economic exposure. Here, transaction reflects the Sainsbury’s risk to exchange rate movements regarding its balance sheet assets and liabilities... The terms of these transactions are established and settled at a given time period and their exposure can easily be measured by accounting systems (Mullem & Verschoor, 2005). The last component of a company’s exposure to currency fluctuations is called competitive or economic exposure. As exchange rate variations affect the relative prices of goods sold in different countries, they affect a firm’s competitive position and indirectly influence its economic environment and future growth possibilities (Mullem & Verschoor, 2005). Although a firm may hedge its foreign exchange contracts, limiting its transaction exposure, economic exposure is difficult to estimate and further, hedge. At Sainsbury group, economic exposure arises because future profits from operating as importer or exporter depend on exchange rates of the counter party currency, and due to its nature, this type of exposure is difficult to mute. (Faff & Iorio 2001, Mullem & Verschoor). Here, because Sainsbury source some of its products from outside, it is liable to foreign exchange exposures. It profits is a function of foreign exchange exposures especially to those items sourced from outside (Mullem & Verschoor, 2005). However, there is greater complexity between the relationship between exchange rate fluctuations and competitiveness and this leads to difficulty in correctly estimating economic exposure and hence hedging it efficiently (Mullem & Verschoor, 2005). Sainsury as a supermarket that do business abroad must be ready to account for changes in exchange rates that lead to variability in their cash flows. (Solt & Lee, 2001). Because of foreign exchange exposures and risks, the management of Sainsbury group has created a special department to manage this. This is the treasury department. Transaction exposure reflects the risk that exchange rates change between the time a transaction is recorded and the time actual receipt of cash or payment of cash is made. (Solt & Lee, 2001). Due to its short-term nature futures and forwards can be used to hedge transaction exposure and thereby eliminate its influence on the value of a firm. (Solt & Lee, 2001). Economic exposure on the other hand is the long-term effect of exchange rate changes on the future cash flows and thereby on stock returns. (Solt & Lee, 2001). The table below summarises the different types of exchange rate risk faced by Sainsbury in particular: Comparison of translation, transaction and operating Exposure Translation exposure Operating exposure Fluctuations in income statements items and book values of balance sheet assets and liabilities that are caused by exchange rate fluctuations. Subsequent exchange rate gains and losses are determined by accounting rules and reflect nominal gains and losses only. The measurement of accounting exposure is retrospective that is it is applied to prior period accounts. Its only impact is on liability and assets that already exist. Movements in the amount of future operating cash flows occurring as a result of fluctuations in exchange rates. Subsequent exchange translation gains and losses are determined by changes in the firm’s future competitive position and are real. The measurement of operating exposure is prospective That is it is based on future periods unlike the retrospective measurement applied to translation exposure. The impacts of operating exposure are more serious than those of translation exposure as it affects revenues and costs associated with future sales. Taken from Shapiro (2003). N.B: Transaction exposure is common to both translation and operating exposure. That is why I have not mentioned it in the table. According to the company’s (2008) report, Sainsbury Group’s activities expose it to a variety of financial risks including liquidity risk, credit risk and market risk arising from movements in exchange rates and interest rates. At Sainsbury Group, the risk management policies are designed to minimise potential adverse effects on the Group’s financial performance by identifying the various risks and setting appropriate risk limits and controls (Company’s Report 2008). The Finance Committee, a committee of the Board, has on going responsibility for approving treasury activity and specific financial transactions, the authority for which may be delegated. The Treasury Committee, chaired by the Chief Financial Officer, regularly reviews risk positions and monitors performance 1.2.1Ways through Which Sainsbury could manage its foreign exchange exposure Transaction exposure can be managed through well-structured hedging strategies. Hedging refers to the process of establishing an offsetting currency position so as to lock in a home currency value for the currency exposure thus, eliminating risk associated with movements in the currency. Locking in a home currency value means that the strategy is established in such a way that the value of the foreign currency in terms of the home currency to be received or paid at a future date is known with certainty. For example, if we assume that Sainsbury is expecting to receive 10million dollars in 3months. The current exchange rate is 2 US dollars per pound. Therefore the current home currency (US Dollar) value of the future receivable will be 5million pounds. However, because the Sainsbury is unaware of what the exchange rate will be in three months, he is facing foreign exchange risk. If the pound goes below 2 US dollars per pound, he/she will make a foreign exchange loss equal to 10million times the amount of decrease. If the pound goes above 2US dollars per pound he will make a gain. Let’s assume that there is a forward contract on the exchange rate with a forward price of 1.9US dollars per pound. This Sainsbury can decide to sell his dollars receivables forward at the price of 1.9US dollars per pound. By so doing he is locking in a minimum value of 4.5million US dollars (Home currency value) to be received in 3 months. Anything that happens to the exchange rate in three months will not affect his future receivable. Economic Exposure is difficult to manage. However, it can be managed by using Marketing management, pricing strategy and production management. (Shapiro, 2003). From information extracted from the 2008 report, the Group’s core funding is represented by two long-term loans secured over property assets held in two subsidiary companies. The loans comprise £1,159 million with a legal maturity of April 2018 and £867 million with a legal maturity of 2036. The Group maintains a £400 million committed revolving credit facility maturing February 2012 to provide additional liquidity. Interest on drawings under the facility is charged at a margin over LIBOR ranging from 37.5 basis points to 75 basis points linked to the Group’s latest reported fixed charge cover ratio. There are £nil drawings under this facility (2007: £nil drawings) (Report 2008). How the Recent Financial Crisis Have affected the Activities of Sainsbury Today for example the recent financial crisis have affected almost all institutions the world over. The main issue is the weakening of property prices in the US. Banks have issued a lot of mortgaged-backed loans and it is unlikely that they will recover these loans given falling property prices. Owing to this, a lot of banks are witnessing serious crises including profit declines, share price declines, and layoff of staff. Sainsbury group banking segment is not left out of this global catastrophe. For example, CitiGroup on Tuesday January 22nd announced a $10billion dollar loss and a $1.8billion dollar write-down and attributed it to the credit crunch. Merrill Lynch also announced an approximate loss of over $10billion in the latest quarter. (Investor Guide, 2008). According to reports from CNN Money.com by Ellis (2008) Merrill Lynch alongside recording a $10billion dollar loss has written down approximately $14.6billion as a result of the credit crunch. Its shares witnessed an 8% drop on Thursday 17th January. At the level of the group forecast of the company’s activities for the 2009 financial year will fall, by 11%. This is attributed to a fall in consumer’s spending, and increase currency exposures and swap fees. (Report 2008). The stock of Sainsbury toady has falling to 331pence due to the global financial crisis. Although some investors hoped that a larger package would turn things around, others contended that a self discipline in the market was necessary and that any government action might be unable to make an immediate turn around. The stimulus plan was therefore considered by many investors as being in the short-run. (Investor Guide, 2008). Other effect include the laying off of workers. 2.0Impact of Share Valuation on the Impact of Sainsbury Supermarket Deregulation of financial markets, the new information technology has eased the provision and search of finance. Millions of shares are traded every day on the world’s stock markets. (Penman, 2003). Investors who trade on these stocks are often forced to ask themselves whether they are buying or selling at the right price. (Penman, 2003). They often attempt to provide answers to these questions by turning to various media including internet chat rooms, printed press, “talking heads” on television and financial networks, who often voice opinions on what they feel the stock prices should be. (Penman, 2003). In addition, investors consult investment analysts who provide an almost endless stream of information and recommendations to sort out. There are often claims that some shares are undervalued and vice versa. (Penman, 2003). Share valuation is one way used to convey the actual worth of a company. Through this, the signaling hypothesis strikes investors on which company has performed best and which has performed list. These investment mechanisms appear to be very simple, as they do not require much effort. (Penman, 2003: pp 3). However, both investors run risks that are even more than the risks of the firms they are investing in since they can either pay too much or sell for less and as a result suffer a decrease in returns on their investments. (Penman, 2003). Thus, share valuation conveys to investors the actual worth of a company. Using 2007, 2008 income statement figures this supermarket will be valued as at this date. Valuation of Sainsbury Plc Sainsbury paid out more dividends than profits made in 2008. Dividend per share was 19.1pence/share as opposed to 19.2pence per share in 2007. were paid out as dividends whereas its profit was only £58 million. We therefore assume that the growth rate in dividends is expected to be 0. the dividend yield is given by 1.4% as reported in the company’s website. There is not enough information for us to estimate a capitalization rate for the company. For example even if we want to use the capital asset pricing model, we do not know the beta of the stock neither do we know the market return nor the risk-free rate of return. However, we will make an assumption here that since both Sainsbury and Tesco are in the same industry, they should face the same risk and therefore should have the same cost of equity capital of 13.7%. From the forgoing if we assume also that the company’s dividends will remain constant at £536 million then we can calculate a value for the firm by simply capitalizing these dividends. That is we will consider it to be perpetuity. Applying the cost of capital of 13.7% we can calculate a value for Sainsbury as follows: V2007 = 536,000,000/.137 = £39124081956. The dividend per share in 2007 was 19.2p. The company paid out a total amount of £536million. This corresponds to a total number of shares of £536million/19.2p = 27916666.66. Therefore the value per share is given by £39124081956/27916666.66. = 140.4p. The current share price 331.00p while the value calculated here is only 140.4p. In addition, the ROE is only 1.4%, which is far below the cost of equity capital. Therefore, we recommend a sell decision in this case. Note all figures are extracted from the 2008/2007 Report. This was as a result of the fact that investors began shifting away from equities into bonds, which resulted in the fall in stock prices. (Investor Guide, 2008). 3.0 Impact of Capital investment appraisals tools on Sainsbury Supermarket Adler (2000) suggests that strategic investment decision making involves the process of identifying, evaluating, and selecting projects that are likely to have a big impact on a companys competitive advantage. Strategic investment decisions influence what the company is doing, that is, the set of products and services as well as their attributes that it offers to customers. These decisions also influence where the company offers these products and services and how it offers them. (Adler, 2000). It is therefore very essential to ensure that the right decision is made as regards the products and services on offer, where such products are offered and how they are offered. Investment decision making involves the elements of a classic cost-benefit analysis. (Adler, 2000). According to Akalu and Turner (2001, 2002) finding a reliable method of investment appraisal is not only a matter of concern for company management. Investment appraisal has now become a matter of concern to both shareholders and investors. (Turner, 2001, 2002). Ekanem and Smallbone (2007) argue that there are two perspectives on investment appraisal. These include the neoclassical perspective and the behavioural or stakeholder perspective. The neoclassical perspective, also known as the shareholder value perspective forces management to meet the demands from the owners to a higher extent than before (higher benefits at a lower cost). (Sandahl and Sjögren, 2003). The main investment appraisal techniques under this perspective include Discounted Cash Flow (DCF) techniques (e.g., Brien, 1997; Lumby, 1994; Thomas, 2001) cited in Ekanem and Smallbone (2007); the payback method, or the Accounting Rate of Return (ARR) method. (Ekanem and Smallbone, 2007). The impact of these methods on Sainsbury lies in better resource management and allocation.  The above discussion leads us to conclude that there are two important perspectives that need to be considered when making investment decisions. These include the shareholder perspective and the stakeholder perspective. While shareholders require the company to make superior profits, stakeholders such as employees, creditors, customers, environmental agencies require the company to satisfy a varying degree of needs. It has been argued that, it is only through the satisfaction of the needs of all stakeholders that shareholder value can be maximized. This is where these investment appraisal techniques drive Sainsbury’s to. 4.0 Conclusion and Recommendation The aim of this paper was to examine the impact of three important topics to the activities of a business. Focusing on Sainsbury, the study concludes that, because an organization is part of the environment, these tools gauge against organization decision towards shareholders value creation. In the course of the study, we realized that, these tools are indispensable to the activities of present day business. Appendix 1 The constant growth dividend model can be written as follows: , ........................(1) (Bodie et al, 2002) Where: is the intrinsic value of the firm at time 0 is the current dividend on the stock at time 0. g is the growth rate in dividends r is the capitalizations rate. If we assume that we want to value the firm say for the next 5 years from 2006 to 2011, then we can write the current value of the firm thus where is the forecasted price at which the stock can sell at the year 2012. We know that r =(Bodie et al, 2002) Where is the dividend yield on the stock. References Adler R. W. (2000). Strategic Investment Decision Appraisal techniques: The Old and the New. Business Horizons. Pp. 15-22  Akalu M. M., Turner R. (2002). Investment appraisal process in the banking and finance industry. Erasmus Research Institute of Management.   Bodie Z. Kane A., Marcus A. J. (2002). Investments. 5th Ediction. McGraw-Hill Ekanem I., Smallbone D. (2007). Learning in Small Manufacturing firms. The case of Investment Decision-making behaviour. International Small Business Journal, vol. 25, No. 2, pp. 107-129. Investor Guide (2008; 2009) www.investorguide.com Ellis D. (2008). Merrill swings to a record $10 billion loss Nations largest brokerage gets battered by $14.6 billion in writedowns, and hires former Goldman risk officer. January 17 2008: 2:08 PM EST. Fraser S . P., Pantzalis C. (2004). Foreign exchange rate exposure of US multinational corporations: a firm-specific approach Journal of Multinational Financial Management Vol. 14, pp 261-281. Mullem A., Willem F.C., Verschoor (2005). Asymmetric foreign exchange risk exposure: Evidence from U.S. multinational firms. Journal of Empirical Finance. Vol. 13, pp 495-518. Penman S. H. (2003). Financial Statement Analysis and Securities Valuation. Second International Edition. McGraw-Hill Sandhahl G., Sjögren S. (2005). Capital budgeting methods among Swedens largest groups of companies. The state of the art and a comparison with earlier studies. International Journal of Production Economics, vol 84, pp. 51-69.  Shapiro A.C.(2003). Multinational Financial Management. Seventh Edition Wiley and Sons Inc. Solt M. E., Lee W. Y. (2001). Economic exposure and hysteresis Evidence from German, Japanese, and U.S. stock returns Global Finance Journal. Pp 217-235 http://www.sainsburys.co.uk/graduates/introducing/ourhistory.asp http://www.j-sainsbury.com/files/reports/cr2006/index.asp?pageid=40#opinion http://www.j-sainsbury.com/files/reports/cr2006/index.asp?pageid=65 Read More