Finance Case Study Example Tesco Plc

A note on the figures: Every number in this model — share prices, debt balances, cash flows, betas and rates — is a rounded, illustrative value chosen to make the method clear. They are not Tesco plc’s reported results and should not be cited as such. The purpose is to demonstrate how a corporate finance analyst structures a capital-structure and valuation case, not to report on the company’s actual accounts.

Introduction and Company Background

Capital structure — the mix of debt and equity a company uses to fund its assets — sits at the heart of corporate finance because it shapes both the risk borne by shareholders and the discount rate applied to future cash flows. This case study uses Tesco plc, one of the United Kingdom’s largest grocery retailers, as a vehicle for showing how an analyst moves from a firm’s financing decisions to an estimate of its intrinsic value. The retailer operates in a mature, competitive and relatively low-margin sector, which makes it an instructive subject: cash flows are comparatively stable and predictable, yet margins are thin, so small changes in the cost of capital have a material effect on value.

A grocery business of this scale typically funds itself through a combination of retained earnings, long-term bonds, bank facilities and, increasingly, capitalised lease liabilities arising from its store estate. The balance struck between these sources determines the firm’s financial risk, its exposure to refinancing and interest-rate movements, and the signal it sends to the capital markets. Because food retail generates resilient demand through the economic cycle, a defensive business of this kind can usually support a moderate level of gearing without the acute distress costs that a cyclical manufacturer might face.

The analysis that follows is organised around the three analytical pillars a Masters-level corporate finance assignment is expected to demonstrate: gearing and capital-structure measurement, estimation of the weighted average cost of capital, and a discounted cash flow valuation. Each is grounded in established theory, worked through with transparent calculations, and then interpreted in the specific context of a large grocer. The case closes with recommendations for the finance function and a reflection on the limitations of the approach. Throughout, the aim is to model good analytical practice: stating assumptions explicitly, showing the workings, and treating every output as a conditional estimate rather than a precise fact.

Case Context and Key Issues

The scenario for this case places the reader in the position of an analyst in the group treasury and corporate development team. The board has asked for a review of two linked questions. First, is the current financing mix appropriate, or should the firm move towards more or less debt? Second, what is the intrinsic value of the equity, and how does that compare with the market’s valuation? These questions cannot be answered in isolation, because the chosen capital structure directly determines the discount rate used in the valuation. A change in gearing alters both the cost of equity and the weights applied to debt and equity, and therefore the enterprise value itself.

The Financing Dilemma

The first issue is whether the firm is carrying an efficient amount of debt. Debt is cheaper than equity because lenders accept a lower return for a prior, contractual claim on cash flows, and because interest is tax-deductible. Taken alone, this argues for more borrowing. Against that stands the rising probability and cost of financial distress as leverage climbs: tighter covenants, a weaker credit rating, higher refinancing risk and, for a retailer, the danger that suppliers and landlords lose confidence. The treasury team must therefore identify the point at which the marginal tax benefit of an extra pound of debt is just offset by the marginal expected cost of distress.

The Valuation Question

The second issue is valuation. The board is considering a possible share buy-back and wants to know whether the equity is cheap, fairly priced or expensive relative to a fundamental estimate. A discounted cash flow model offers an intrinsic benchmark that is independent of short-term market sentiment, but it is only as reliable as its inputs. The sensitivity of the output to the cost of capital and the assumed long-term growth rate is itself a central finding, because it tells the board how much confidence to place in any single number. These two issues — the right financing mix and the fair value of the equity — frame the remainder of the analysis.

Theoretical Framework

A credible capital-structure analysis must be anchored in theory rather than rules of thumb. Three bodies of work are especially relevant: the Modigliani–Miller propositions and the trade-off theory that extends them, the pecking order theory of financing preferences, and the agency perspective on the discipline that debt imposes on managers.

Modigliani–Miller and the Trade-off Theory

Modigliani and Miller (1958) established the foundational result that, in a world of perfect capital markets with no taxes, bankruptcy costs or information asymmetry, a firm’s value is independent of how it is financed. Their Proposition I holds that the total value of the firm is set by the earning power and risk of its underlying assets, not by the way claims on those assets are divided between debt and equity. Proposition II adds that the cost of equity rises linearly with gearing, precisely offsetting the apparent cheapness of debt, so the weighted average cost of capital stays constant.

The authors later relaxed the no-tax assumption. Modigliani and Miller (1963) showed that, once interest is made tax-deductible, debt creates a tax shield that raises firm value by the present value of the tax saved. In this corrected world the logical conclusion is extreme — firms should be almost entirely debt-financed — which is plainly not what is observed. The trade-off theory resolves the tension by introducing the costs of financial distress. As leverage rises, the expected present value of distress costs grows, and the optimal capital structure is reached where the marginal value of the tax shield equals the marginal cost of distress (Myers, 1984). For a defensive retailer with stable cash flows, distress costs rise slowly, so the theory predicts a comfortable tolerance for moderate gearing.

Pecking Order and Agency Considerations

Myers and Majluf (1984) offered a different lens. Under their pecking order theory, information asymmetry between managers and investors makes firms prefer internal funds first, then debt, and only issue equity as a last resort, because an equity issue tends to be read by the market as a signal that managers believe the shares are overvalued. This theory explains why profitable firms often carry less debt than the trade-off model would predict: they simply fund investment from retained earnings. Jensen and Meckling (1976) add the agency dimension, arguing that debt can be value-enhancing because the obligation to service it disciplines managers, reducing the temptation to over-invest free cash flow in low-return projects. Taken together, these theories suggest that the firm’s financing choice should balance the tax advantages and disciplining benefits of debt against distress costs and the signalling penalties of issuing equity — a balance the empirical workings below attempt to quantify.

Analysis: Capital Structure and Gearing

The starting point is to measure how geared the firm currently is. Gearing can be expressed in several complementary ways, each answering a slightly different question. The table below sets out the key ratios using illustrative market values: equity of £22,000m (share price multiplied by shares in issue), gross debt of £10,000m including capitalised leases, net debt of £9,000m after cash, EBITDA of £4,000m, EBIT of £2,600m and annual interest of £450m.

Figures are illustrative and rounded for teaching; they do not represent Tesco plc’s reported accounts.

These ratios paint a consistent picture of a moderately and comfortably geared business. A debt-to-capital ratio of around 31% is typical of a large investment-grade retailer and is well short of the levels at which distress costs begin to dominate. Net debt of 2.25 times EBITDA sits within the range that most rating agencies associate with a solid investment-grade profile, and interest cover of close to six times indicates that operating profit comfortably exceeds the firm’s contractual interest burden. In trade-off terms, the firm appears to be operating on the relatively flat part of the curve where the tax shield is being captured without the firm approaching the steep rise in expected distress costs.

Two features specific to grocery retail deserve emphasis. First, a large share of the debt figure reflects capitalised lease liabilities on stores and distribution centres rather than conventional borrowing, which behaves differently from a bond in a downturn. Second, the sector’s negative working capital cycle — customers pay immediately while suppliers are paid on terms — provides an unusually dependable source of operating cash that effectively supplements the firm’s funding. Both factors support a somewhat higher debt tolerance than a naive reading of the headline ratios would suggest, consistent with the trade-off prediction for a stable, cash-generative business.

Analysis: Cost of Capital (WACC)

With the capital structure measured, the next task is to estimate the weighted average cost of capital, the blended required return on the firm’s debt and equity and the discount rate used in the valuation. The WACC is defined as:

WACC = (E ÷ V) × R_e + (D ÷ V) × R_d × (1 − T_c)

Cost of Equity Using CAPM

The cost of equity is estimated with the Capital Asset Pricing Model (Sharpe, 1964; Lintner, 1965), which holds that the required return on a share equals the risk-free rate plus a premium for the stock’s systematic risk. The model is written as R_e = R_f + β(R_m − R_f). Using an illustrative risk-free rate of 4.0% drawn from long-dated gilts, an equity risk premium of 5.0%, and an equity beta of 0.80 that reflects the defensive, below-market volatility typical of food retail, the cost of equity is 4.0% + 0.80 × 5.0% = 8.0%. The sub-market beta is intuitive: demand for groceries is relatively insensitive to the economic cycle, so the shares move less than the market as a whole.

Cost of Debt and the Tax Shield

The cost of debt is the yield the firm would pay on new long-term borrowing, estimated here at 5.0% before tax. Because interest is deductible, the relevant figure for the WACC is the after-tax cost, R_d(1 − T_c). Applying the UK main corporation tax rate of 25%, the after-tax cost of debt is 5.0% × (1 − 0.25) = 3.75%. This tax shield is the mechanism, formalised by Modigliani and Miller (1963), through which debt lowers the overall cost of capital.

The Weighted Average Cost of Capital

Combining the components with the market-value weights derived earlier produces the WACC. The full workings are set out below.

WACC = 0.6875 × 8.00% + 0.3125 × 3.75% = 5.50% + 1.17% = 6.67%. All inputs illustrative.

The resulting WACC of approximately 6.67% is the single most important output of this stage, because the valuation is highly sensitive to it. Two observations follow. First, equity dominates the blend: at nearly 69% of capital it contributes the large majority of the cost, which is why the firm’s modest beta matters so much. Second, the gap between the 8.0% cost of equity and the 3.75% after-tax cost of debt quantifies the incentive to use debt — but, as Modigliani and Miller’s Proposition II warns, adding debt would raise the equity beta and therefore the cost of equity, partially offsetting the saving. A rigorous analysis would re-lever the beta for any proposed change in gearing before concluding that more debt lowers the WACC.

Analysis: DCF Valuation

The discounted cash flow model estimates intrinsic value by forecasting the firm’s free cash flows, discounting them at the WACC, and adding the present value of a terminal value that captures cash flows beyond the explicit horizon (Damodaran, 2012; Koller, Goedhart and Wessels, 2020). Because the WACC is used as the discount rate, the valuation is built on free cash flow to the firm (FCFF), the cash available to all providers of capital, defined as EBIT × (1 − T_c) + depreciation and amortisation − capital expenditure − the increase in net working capital.

Free Cash Flow Forecast

The forecast assumes modest revenue growth of around 3% a year, broadly stable operating margins, and reinvestment roughly in line with depreciation, consistent with a mature retailer in a maintenance phase. These assumptions generate the illustrative five-year FCFF profile below, which is then discounted at the 6.67% WACC.

Sum of the present value of explicit free cash flows = £6,979m. Figures illustrative.

Terminal Value and Enterprise Value

Beyond year five the firm is assumed to grow at a sustainable long-term rate of 2.0%, broadly in line with long-run nominal GDP growth, a conservative ceiling that avoids the error of letting a company grow faster than the economy forever. The terminal value at the end of year five is calculated with the Gordon growth formula, TV = FCFF₅ × (1 + g) ÷ (WACC − g) = 1,900 × 1.02 ÷ (0.0667 − 0.02) = £41,499m. This is then discounted back to the present and combined with the explicit cash flows to give the enterprise value, from which net debt is deducted to arrive at the equity value.

Implied equity value of £28,029m is about 27% above the illustrative market capitalisation of £22,000m. Figures illustrative.

Two features of the result are worth highlighting for the board. First, the terminal value accounts for roughly 81% of the enterprise value (£30,050m of £37,029m), which is typical for a low-growth, long-lived business but also a warning: the valuation rests heavily on assumptions about the distant future that cannot be observed. Second, the implied equity value of £28,029m stands about 27% above the illustrative market capitalisation of £22,000m, which on its face suggests the shares are undervalued. That conclusion should be treated cautiously until it is stress-tested, which is the purpose of the sensitivity analysis.

Sensitivity Analysis

Because the enterprise value depends so heavily on the WACC and the terminal growth rate, a responsible analyst reports a range rather than a point estimate. The matrix below recalculates enterprise value across a plausible band of each input, holding the cash-flow forecast constant.

Enterprise value ranges from £29.2bn to £48.7bn across the band. Figures illustrative.

The matrix is sobering. A movement of less than one percentage point in either direction produces a swing in enterprise value of many billions of pounds. At a WACC of 7.5% with 1.5% terminal growth, the enterprise value of £29,210m implies an equity value of about £20,210m, below the illustrative market capitalisation; at a WACC of 6.0% with 2.5% growth it balloons to nearly £48,700m. The central message for the board is that the apparent 27% undervaluation is real only if the central assumptions hold, and that the firm’s value is far more sensitive to its cost of capital than to operational performance over the explicit forecast window. This reinforces why the capital-structure decision, which drives the WACC, is inseparable from the valuation.

Discussion and Recommendations

Bringing the three strands together produces a coherent view. The gearing analysis shows a firm that is moderately leveraged and well inside its debt capacity. The WACC analysis quantifies the cost advantage of debt while flagging the offsetting rise in the cost of equity that further borrowing would bring. The DCF, read alongside its sensitivity table, suggests the equity may be modestly undervalued but makes clear how fragile that conclusion is. On this basis, four recommendations follow.

1. Maintain a target gearing band rather than a single ratio. Given the stable cash flows and the comfortable interest cover, a net-debt-to-EBITDA target of roughly 2.0 to 2.5 times captures most of the tax-shield benefit while preserving an investment-grade rating and the confidence of suppliers and landlords. This is consistent with the trade-off theory’s prediction for a defensive business.
2. Fund the proposed buy-back cautiously. If the board proceeds with returning capital, a measured debt-funded buy-back would modestly increase the tax shield and signal management’s confidence, in line with the agency argument of Jensen and Meckling (1976). However, the programme should be sized so that gearing remains within the target band even under a stressed-earnings scenario.
3. Re-lever the beta before claiming any WACC saving. The temptation to conclude that more debt automatically lowers the WACC should be resisted. Any proposed change in capital structure must be run through a re-levered beta so that the higher cost of equity is captured, as Proposition II requires.
4. Treat the DCF as a range, not a verdict. The board should anchor on the sensitivity matrix rather than the single £28bn equity figure, and triangulate the DCF against market-based multiples such as EV/EBITDA before acting.

It is important to acknowledge the limitations of the analysis. The DCF depends on a terminal value that supplies four-fifths of the enterprise value and on a cost of capital that is itself an estimate built on assumed inputs. The CAPM, while standard, is an imperfect description of expected returns, and empirical work has long questioned the strength of the relationship between beta and realised returns (Fama and French, 2004). Survey evidence also shows that managers in practice blend theory with judgement and rules of thumb when they set hurdle rates and financing policy (Graham and Harvey, 2001). A full board paper would therefore complement this model with scenario analysis, a review of the lease-adjusted debt position, and a comparison against sector peers.

Conclusion

This model case study has shown how the pieces of a corporate finance analysis fit together. Starting from the measurement of gearing, it established that the illustrative firm is moderately and prudently leveraged, with ample interest cover and a debt load well within the capacity of a defensive grocery retailer. It then estimated a weighted average cost of capital of approximately 6.67%, built transparently from a CAPM cost of equity of 8.0% and an after-tax cost of debt of 3.75%, and used that rate to discount a five-year free cash flow forecast and terminal value to an enterprise value of about £37bn and an equity value of about £28bn. The sensitivity analysis then demonstrated that this figure is highly conditional on the cost of capital and the assumed long-term growth rate, which is precisely why the financing decision and the valuation must be considered together.

For a Masters-level reader, the central lesson is methodological rather than numerical. A strong corporate finance case does not hinge on producing a single confident number; it hinges on grounding each step in theory, stating assumptions openly, showing the workings, and being candid about the range of plausible outcomes. The Modigliani–Miller framework, the trade-off and pecking order theories, the CAPM and the DCF are complementary tools, each illuminating one facet of the same decision. Used together, and with appropriate humility about their limitations, they allow an analyst to give a board a defensible, evidence-based view of both how a company should be financed and what its equity is worth.

References

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