FIN4505: CORPORATE FINANCE COURSEWORK

Module leader: Dr. Ngoc Nguyen

Student: Stela Chatzinaki (M00340250)

London, January 20th, 2012

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Table of Contents

I. Introduction ....................................................................................................................... 2

II. Corporate Governance and Shareholder Structure ............................................................. 3

2.1. The Chief Executive Officer ....................................................................................... 3

2.2. Board of Directors ...................................................................................................... 4

2.3. Financial Markets Considerations ............................................................................... 5

2.4. Social Constraints ....................................................................................................... 7

2.5. Shareholder Analysis .................................................................................................. 8

III. Financial Performance Analysis .................................................................................... 11

3.1. Liquidity ratios ......................................................................................................... 11

3.2. Profitability Ratios .................................................................................................... 13

3.3. Financial Strength Ratios .......................................................................................... 14

3.4 Efficiency Ratio ......................................................................................................... 15

3.5 Shareholders’ Ratios .................................................................................................. 15

3.6. Limitations of Ratio Analysis .................................................................................... 16

IV. Risk Analysis ................................................................................................................ 18

4.1. Risk Profile ............................................................................................................... 18

4.2. Performance Profile .................................................................................................. 20

4.3. Expected Return on Equity and Cost of Equity.......................................................... 21

4.4. Cost of Debt.............................................................................................................. 22

4.5. Cost of Capital .......................................................................................................... 22

V. Capital Structure Analysis .............................................................................................. 25

5.1. Sources of Financing ................................................................................................ 25

5.2. Trade off on Debt versus Equity ............................................................................... 27

5.2.1 Benefits of Debt .................................................................................................. 27

5.2.2. Costs of Debt ...................................................................................................... 28

VI. Conclusion .................................................................................................................... 30

Bibliography ....................................................................................................................... 31

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I. Introduction

Carclo PLC is a UK based public company which operates in the subsector of specialty

chemicals. The company was founded in 1924 and initially was operating as a card clothing

manufacturer. Through the years, the group has transformed into a technology-led plastics

business with global presence. Particularly, the main segments of Carclo’s operations are the

technical plastics and precision products. Additionally, the company aims to develop new

technologies and has invested in the Conductive Inkjet Technology and Platform Diagnostics.

The company currently has 1074 employees and apart from England, Carclo has a significant

number of subsidiaries in other countries as well. The main countries of incorporation are the

USA, China, Czech Republic, India and France. Finally, Carclo Plc was first listed on LSE in

1959 and currently its shares are quoted in the FTSE Small Cap Index with a market

capitalisation of £177.8 m in at December 2011 (LSE, 2011).

The following analysis aims to provide a comprehensive business overview of Carclo Plc.

Particularly, in the first section of this analysis the corporate governance and shareholder

structure of the firm is discussed. The next part focuses on the financial performance of the

firm by using a range of financial ratios. The third part of the study seeks to evaluate the

company’s risk profile, while the study continues by analysing the capital structure of the

firm. Finally, the study ends with a recommendation and conclusion section.

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II. Corporate Governance and Shareholder Structure

2.1. The Chief Executive Officer

The Chief Executive Officer (CEO) of a firm plays a significant role in the overall strategy of

the firm. The present CEO of Carclo Plc is Ian Williamson, age 60. Williamson has become a

director of the firm in June 1995, while in July 1995 he was appointed CEO, a position that

holds until today. He also was a former CEO of BBA Group Plc, whereas now he is a non-

executive director of the Suprajit Engineering Limited in India. This previous experience as a

CEO along with the 16 years experience as Carclo’s CEO enables him to have a deep

knowledge regarding the operations of the firm and to formulate a successful strategy for the

firm and its shareholders.

The CEO’s compensation scheme for the financial year ends in 31st of March 2011 consists

of the base salary, bonus related to the performance (Short Term Incentive) and a long term

incentive plan (share options). In particular, the CEO’s salary was £237,000 and it was in

accordance with his contract and considering the base salaries of similar positions in

equivalent companies. No performance related bonuses were paid because the Short Term

Incentive plan was suspended due to the general economic recession and the company did not

manage to increase its earnings above to £7.1 m, which was the requirement for bonuses

payments. In addition, Williamson was paid £12,000 as benefits and £47,380 (20% of the

salary) as pension entitlements.

Concerning the long term incentive plan (the ‘PSP’), the CEO received a vested payment of

£137,063 as part of the PSP 2007 award scheme, while under the new PSP program he

awarded 609,000 shares with share price of 155p.This award is related to the performance of

the company for the next three years. The performance targets are linked to the share prices

and the position of the company in the FTSE Small Cap Index. Additionally, in July 2010 the

CEO exercised approved options over 20,000 shares and his shareholding increased by

20,000 shares. Ian Williamson currently holds 687,823 ordinary shares and 258,000 options

which constitute around 1.5% of the total share capital of the company which is 61,561,702

numbers of shares. In this context, and Jensen and Zinnerman (1985) found that there is a

positive relationship between CEO compensation and share prices, which affect positively the

shareholders’ wealth.

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2.2. Board of Directors

The Board of Directors of Carclo Plc consisted of five members: this include one chairman,

two executive directors and two independent non-executive directors (Annual report, 2011,

pp. 17). Since the chairman has appointed as an independent director, the non-executive

directors constitute the 60% of the board, while the remained 40% is comprised by executive

directors. Given the fact that Carclo is considered as smaller1 firm and the Combined Code on

Corporate Governance (2003) refers that the board size should not be so large so as to be

‘unwieldy’, the size of the Carclo’s board appears to be sufficient enough regarding to its

fiduciary responsibilities. The company has three board committees: the Audit, the

Remuneration and the Nomination Committee. Each committee should include at least three

independent directors according to the combined code (provisions A.4.1; B.2.1. and C.3.1.).

Notably, the company has disclosed an exception regarding these provisions since the Group

Chairman is a member of these committees (annual report, 2011, pp.26). However, since the

Group Chairman was considered independent on appointment and the Code refers that in

smaller firms (such in Carclo’s case) the committees can be comprised of only two

independent directors, this exception appears not to affect the degree of board independence.

The table below presents the composition and the remuneration scheme of the board:

Table 2.1. Board of Directors

Directors Appointment Date Age Salary

(£000)

Benefits

(£000)

Ordinary Shares

(Units)

Chairman

Christopher Ross 1 January 2006 66 69 - 81,500

Executive Directors

Ian Williamson 1 July 1995 60 237 12 687,823

Robert Brooksbank 1 April 2004 45 138 12 185,450

Non-Executive

Directors

Michael Derbyshire 1 January 2006 63 28 - 40,000

Bill Tame 1 January 2006 56 28 - 29,000

From the table it is obvious that the positions of the CEO and the Chairman are held by

different persons (Ian Williamson as CEO and Christopher Ross as Chairman), which is

consistent with the provision of A.2.1. The CEO has relevant vast knowledge and expertise in

the field as mentioned above, while the Chairman is a chartered engineer and he is currently

1 According to the Combined Code, companies below the FTSE 350 Index considered as small.

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deputy chairman of Manganese Bronze Holdings plc and a non executive director of the

Electric Car Corporation Plc and Chargemaster Plc. Additionally, R. Brooksbank who is the

Chief Financial Officer of Carclo is a qualified chartered accountant with a career in Ernst &

Young. Accordingly, the independent non-executive directors include people with knowledge

and expertise in the field. Particularly, M. Derbyshire is a chemical engineer and he is also

chairman of Radius systems Ltd, while B. Tame is currently finance director of Babcock

International Group. Therefore, Carclo’s board includes qualified and experienced persons

who can contribute efficiently and effectively in the strategic decisions of the company.

Moreover, it is apparent that the members of the board hold positions in other companies, and

thus they have a wide range of connections outside the company, however from the

information provided in the annual report no one has other connections to the firm (e.g.

suppliers, customers) or represent other major shareholders of Carclo.

According to the annual report (pp. 16), the directors hold 2% of total shares in issue with the

CEO and the Group Finance Director to hold the highest proportion. Therefore, no one of

directors can be considered as a major shareholder of the company and the separation of

management and shareholders (i.e. ownership) is clear.

Overall, the governance structure of the Carclo Plc appears to correspond with the

recommendations of the Combined Code in relation to the board independence and

composition. In particular, the 60% of the board directors are independent while the positions

of CEO and chairman are holding by different persons. Additionally, the members of boards

seem to be qualified and experienced enough to bring new knowledge into the company.

Therefore, Carclo’s board appears efficient and effective enough to fulfil its fiduciary

responsibilities and maximize shareholders’ wealth. In this sense, Pearce and Zahra (1992)

state the significance of the independent directors and argue that non-executive directors may

act as effective monitors of executive directors and they have a positive effect on the firm’s

performance.

2.3. Financial Markets Considerations

Carclo Plc trades on the London Stock Exchange and belongs to the FTSE All-Share, FTSE

All-Share (ex IT), FTSE Small Cap and FTSE Small Cap (ex IT) Indexes. In the last year,

Carclo's share price has ranged from 219.50p to 352.50p and brokers are currently rating this

stock as 'buy'(Yahoo Finance, 2011). According to analyst’s information provided in Carclo’s

website, three analysts are currently following the company: the Brewin Dolphin, Charles

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Stanley and Arden Partners. In order to examine how widely Carclo’s shares are held and

traded, the following charts present the share trading volume of Carclo Plc across the 2011,

while a five years history of the volume of shares is presented as well.

Source: Carclo Plc,2012 (available from website)

Chart 2.2 Five Years Volume History

Source: London Stock Exchange, 2012

At first sight it is obvious from the chart 2.2., that the trading volume among 2008 and 2009

was extremely low in comparison to 2010 and 2011. Specifically in 2010 the trading volume

more than doubled, while in 2011 a slight decrease has been observed. In 2010 the volume

trading of Carclo’s shares was higher compared to other years and according to the detailed

share information given in the Carclo’s website the highest volume traded has been observed

in the 29th

of October 2010 when the share price was 218.5p and the volume of shares traded

was 4,009,106 units, which means a total trade value of £875,989,661 m. According to Chart

2.1., the highest level of share volume in 2011 was in the 23rd

June 2011 when the shares

0

500000

1000000

1500000

2000000

2500000

Chart 2.1 Share Trading Volume of 2011

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traded were 1,922,431 units with a share price of 295p.That means a total trade value of

£567,117,145. Given that the total shares of Carclo in 2011 are 61,561,702 units, the

proportion of the floated shares in its highest level is around 3.2 % of the total company

shares. This high volume can be attributed to the fact that in June 2011 the company has

announced the recommendation of increased final and interim dividend payments (Reuters,

2011), which sending a positive signal in the market and may affect positively the share

performance at this period of time.

Overall, the chart 2.1 depicts a low trade volume across 2011, mainly below the 500,000

units. This can be attributed to the fact that Carclo is a small company, trading exclusively in

the FTSE Small Cap Index and has not expanded in other foreign markets. In addition, the

general recession and economic uncertainty in the market during the last years it is likely to

have a negative impact in the share performance. Besides the above limitations, according to

the annual report, Carclo’s Total Shareholders Return (TSR) ranking for the three year

performance period to 30 September 2010 was 13th out of 158 constituents of the FTSE

Small Cap index, which brings the company above to the top quartile of the companies. This

fact in combination with the increasing trend in share prices and the emphasis of the company

to new technological investments implies that the company is likely to attract more investors

in the future.

2.4. Social Constraints

Companies report social and environmental information as part of their corporate social

responsibility (CSR) strategy and by doing so, extend their accountability beyond the

financial accounts, which usually involves reporting regarding the environment, employees,

communities and ethical standards (Gray et al., 1995). Besides the fact that Carclo Plc

considered as a small firm and does not publish a separate corporate social responsibility

report, the annual report includes numerous parts which are indicative of the social

responsibility strategy adopted by the firm.

Particularly the company provides information regarding its environmental policy and states

that its target is to eliminate and minimize the negative environmental impacts from the

pursuit of its various business interests. For this purposes each subsidiary is audited by the

group’s outsourced health, safety and environment manager, while a policy of long term

strategy to minimize, reuse and recycle packaging is adopted by being a member of Valpac.

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As part of its social responsibility, the company encourages the involvement of its

stakeholders such as employees, customers, suppliers and shareholders. For instance,

employee representatives are consulted regularly on a wide range of matters affecting their

current and future interests. Additionally, the company has a policy to give job opportunities

to disabled employees and to consider the cultural differences exist in the various

subsidiaries. Moreover, the company seeks to satisfy the interests of its customers by

providing high quality of products.

Since the 84% of the shares are held by institutional shareholders (annual report, 2011, pp.

16) the involvement and the interests of shareholders are of great importance for the

company. Shareholders are getting involved and provide feedback by participating to annual

general meeting. Furthermore, the company’s management has identified the possible risks

and uncertainties facing the firm (pp 20-22) and ensure that the report has been audited and

that present a true and fair view of the business. This information is of great significance for

shareholders’ future investment decisions.

Additionally, one of the major objective of the firms is to maximize the shareholders wealth

and in this context it can be said that the dividend for the year increased by 10% (from 2.0 p

in 2010 to 2.2 p in 2011).

From the information provided in the annual report and the website, Carclo has not been a

target of social criticism. Besides, Carclo appears to disclose sufficient information in regards

to social and environmental issues and aims to construct a reputation of a good corporate

citizen. Researchers has showed a positive relationship between CSR practices and financial

performance (see for example: Mir and Rahaman, 2011) which contributes to the long term

growth and sustainability of the firm.

2.5. Shareholder Analysis

Shareholders hold voting rights in annual general meetings of the company and as a result

play a significant role in relation to the decision making processes inside the company and

the strategy adopted.

Carclo had 1,688 ordinary shareholders at 31st of March 2011(annual report, 2011). Ten of

these shareholders hold over 500,000 shares. The company is not listed in foreign markets

and thus there are no shares held by non domestic investors. The majority of the shareholders

are institutions, while 2%, is held by the directors. The remained 14% is held by other

individuals. The categories of shareholders are depicted by percentages in the following pie

chart.

Source: Carclo’s annual report, 2011.

As mentioned above, the directors hold 2% of

to mention that during the financial year ends at 31

shares by 20,000.Besides the directors who are considered as ‘insiders’, any shareholder who

hold more than 5% of the total shares can be treated as ‘insider’ as

presents a detail analysis regarding the insider holdings.

Table 2.2.

Insiders

Ruffer LLP

Henderson Global Investors

Schroder Investment Management

J P Morgan Asset Management

Standard Life Investments

Directors

Total Insider Holdings Source: Carclo’s annual report, 2011.

As the table illustrates, the major

investment management institutions

remaining 56.87% is held by outsiders, who in this case involves individual shareholders and

other institutions with small amount of shares held.

suggests that the majority of company’s

2 In this analysis is considered as insider ( 4.99% is close to 5% and their difference is insignificant).

2%14%

Figure 2.3. Category of Shareholders

Institutions

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individuals. The categories of shareholders are depicted by percentages in the following pie

As mentioned above, the directors hold 2% of the total shares of the company and it

to mention that during the financial year ends at 31st March 2011, the CEO

Besides the directors who are considered as ‘insiders’, any shareholder who

hold more than 5% of the total shares can be treated as ‘insider’ as well. The following table

presents a detail analysis regarding the insider holdings.

Table 2.2.Insider Holdings

Units held % Shares

7,782,850 12,64

5,987,591 9,73

4,457,136 7,24

4,018,689 6,53

3,075,359 4,992

1,341,773 2,00

26,663,398 43,13

As the table illustrates, the major shareholders, apart from the directors, are mainly asset and

investment management institutions. The total percentage of insiders is 43.13%

remaining 56.87% is held by outsiders, who in this case involves individual shareholders and

other institutions with small amount of shares held. Thus, Carclo’s ownership structure

suggests that the majority of company’s shares are held by minority shareholders who may

In this analysis is considered as insider ( 4.99% is close to 5% and their difference is insignificant).

84%

14%

Figure 2.3. Category of Shareholders

Institutions Directors Other

individuals. The categories of shareholders are depicted by percentages in the following pie

and it is worth

increased his

Besides the directors who are considered as ‘insiders’, any shareholder who

following table

the directors, are mainly asset and

43.13% and thus the

remaining 56.87% is held by outsiders, who in this case involves individual shareholders and

Thus, Carclo’s ownership structure

shares are held by minority shareholders who may

In this analysis is considered as insider ( 4.99% is close to 5% and their difference is insignificant).

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not have enough interest to ensure and improve the firm value. Indeed, Thomsen and

Pedersen (2000) support that the identity of large owners (i.e. insiders) has important

implications for corporate strategy and performance. Even though the directors have

incentives (e.g. benefits and shares) to act for the interest of other shareholders and maximize

the firm value, in Carclo’s case the separation of ownership and management and the high

proportion of minority shareholders in the governance structure imply the presence of agency

problems. Indeed, Ang et al., (1999) suggests that agency costs for outsider managed firms

are larger; while Singh and Davinson (2003) claim that managerial ownership can

significantly alleviate principal-agent problems.

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III. Financial Performance Analysis

This part aims to analyse the financial performance of Carclo Plc by presenting a range of

financial ratios during the last two years. In order to provide a comprehensive evaluation of

firm’s performance, it is important to compare the company’s ratios with its peer’s figures

and sector figures retrieved from Reuter’s website (2011). The peer group involves Johnson

Matthey Plc, Victrex Plc and Scapa Plc, all operating in the subsector of specialty chemicals.

3.1. Liquidity ratios

In general, liquidity ratios are used to determine a company’s ability to cover its short term

obligations when they fall due.

Table 3.1 Liquidity ratios

Ratios Formula 2010 2011 Peers Average Sector

Approach 1

Current ratio

Current

Assets/Current

Liabilities 1.74 1.48 2.06 1.76

Quick ratio

Cash and

accounts

receivable/Curre

nt liabilities 1.3 1.04 1.36 1.27

Approach 2

Aver.

Collection

period

Accounts

receivable/(Annu

al credit

sales/365)

91.82 days or

3.98 times

77.54 days or

4.71 times

54.43 days or

7.58 times

8.09

times

Inventory

Turnover

Cost of goods

sold/Inventory

7.35 times or

49.6 days

6.7 times or

54.46 days

7.89 times or

92.32 days

6.03

times

Current ratio

The current ratio compares the current assets with current liabilities and depicts the

company’s ability to pay back its short-term liabilities with its short-term assets. The ratio

decreased between 2010 and 2011 from 1.74 to 1.48. This decrease is attributed to the fact

that the current liabilities increased in higher volume than the current assets among 2010 and

2011. Compared to its peer’s average number (2.06) and the sector figure (1.76), Carclo

appears to be weaker in covering its short term liabilities. Even though the higher current

ratio implies a larger safety margin for companies to cover their short term liabilities, Carclo

appears sufficient enough to cover its short term obligations since its current ratio is far more

than one.

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Quick Ratio

The quick ratio measures a company's ability to meet its short-term obligations with its most

liquid assets (cash and receivables). Carclo’s quick ratio for 2010 and 2011 is 1.30 and 1.04

respectively. Again, the figures decreased due to the increase in current liabilities while the

cash in hand decreased slightly between the two years. Carclo’s quick ratio is close to its

peer’s average and the sector; however the decrease in the quick ratio in 2011 suggests that

the company should focus more on its working capital management in order to ensure the

existence of sufficient liquid assets in its balance sheet to cover its current liabilities in the

future.

Average Collection Period

This ratio shows the approximate amount of time that it takes for a company to receive

payments in terms of receivables. The average collection period ratio for 2010 and 2011 is

91.82 days or 3.98 times and 77.54 days or 4.71 times respectively. Carclo reduced its average

collection period by 14 days even if it is still very far from its peer’s average and sector figures. That

means that Carclo has a sale policy to allow extending credit to its customers, which may

create bad debts in the future. This long period is more common in small firms such as Carclo

since they want to attract more customers by providing more favourable payment policies,

however given the risk of illiquidity, Carclo may consider to set up a more secure sales

scheme.

Inventory Turnover

This ratio shows how many times a company's inventory is sold and replaced over a period.

Carclo Plc appears to increase slightly the days that inventories carried from 49.6 days 2010

to 54.46 days in 2011. This is attributable to the increasing inventories among these two

years. The figure of Carclo is quite close to the sector figure while the company appears to

manage its inventories in more quick and efficient way than its competitors (92.32 days).

Management should pay great attention to inventory’s cycle of their company as an excessive

inventory stock for a long period of time may be costly for the company since their market

value may decrease during long period of times.

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3.2. Profitability Ratios

Profitability ratios as financial measures are used to assess a firm’s ability to

generate earnings as compared to its assets.

Table 3.2.Profitability ratios

Ratios Formula 2010 2011

Peers

Average Sector

Operating Return on

Assets

Operating

return/Total

assets 4.9% 5.2% 12.69% 12.20%

Operating Profit

Margin

Operating

profit/Sales 6.8% 7% 14.36% 13.66%

Total Assets Turnover

Sales/Total

assets 0.72 times 0.76 times 1.42 times 1.15 times

FixedAssets Turnover

Sales/Fixed

assets 1.15 1.2 2.52 times N/A

Operating Return on Assets

This ratio provides a measure of how efficient the management is at using its assets to

generate earnings. From the table it can be observed a slight increase from 4.9% to 5.2% in

2011. This means that at 31st March 2011 the managers have generated 5.2 pence of

operating profit for every £1 of assets. Both operating income and total assets of the company

increased slightly among 2010 and 2011, however comparing with the sector figure (12.2%)

and the peer average (12.69%), Carclo’s figures are far too low which indicate that the

managers did not manage their assets effectively. From an investor’s point of view, this

figure is quite important as it shows how effectively the money invested to assets has

converted into net income. Hence, the higher the figure is the better for the investors.

Operating Profit Margin

Operating profit margin indicates the effectiveness of the company in managing its cost of

goods sold and operating expenses that determine the operating profit. Operating profit

margin has risen slightly from 6.8% to 7% between 2010 and 2011. In other words, the

managers make 7 pence operating profit in every £1 of sales. This margin is far from the

sector and peers numbers which are 13.66% and 14.36% respectively and indicate that

managers should adopt more efficient sale policies in order to compete with its competitors

and ensure their position in the industry. These figures are important for investors as well

because the greater the profit the more the investors earnings are per GBP of sales.

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Total Asset Turnover

This ratio is useful to determine the amount of sales that are generated from each GBP of

assets.Carclo’s total asset turnover increased moderately between 2010 and 2011 from 0.72

times to 0.76 times, which mainly is due to the analogous increase in the sales. This means

that Carclo generates 0.76 pence in sales for every £1 invested in assets which is lower than

the sector figure (1.15 times) and its competitors average (1.42 times).

Fixed Asset Turnover

Similarly to the previous ratio analysed, fix asset turnover examines the company’s efficiency

in generating sales from its investment in fixed assets. The results show that the numbers

remained relatively stable between 2010 and 2011. For the year end at 31st March 2011,

Carclo has generated £1.15 in sales for every £1 invested in non- current assets while its

competitors have managed to generate £ 2.52 in sales.

3.3. Financial Strength Ratios

Table 3.3.Financial Strength( or Solvency) ratios

Ratios Formula 2010 2011

Peers

Average Sector

Debt

Ratio

Total debt/Total

assets 60% 53% 48.5% N/A

Times

Interest

Earned

Operating

income/Interest 11.4 times 10.5 times 9.29 times 0.66 times

Debt to Assets ratio

This ratio shows what proportion of firm’s assets is being financed through debt. Particularly,

Carclo’s ratio decreased from 60% in 2010 to 53% in 2011. This reduction can be attributed

to the fall of the total debt and total assets in the balance sheet in 2011. The figure indicates

that Carclo finances 53% of firm’s assets by debt and 47% by equity. According to the table,

Carclo appears to use more debt in specifically financing its assets that its competitors and as

a result the company faces higher risk.

Times Interest Earned

This ratio determines if the company has earned enough profit to cover its interest expenses.

Carclo appears to have relatively high ratios, 11.4 times for 2010 and 10.5 times for 2011.

Carclo’s ratio appears to be slightly over its peer’s group average (9.29). Hence, Carclo

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seems to have sufficient earnings to cover its interest payments. Notably the sector average is

too low (0.66) and thus Carclo appears to face lower risk than the sector as a whole when it

comes with the debt payments such as the interest expenses.

3.4 Efficiency Ratio

Table 3.4.Efficiency ratios

Ratio Formula 2010 2011

Peers

Average Sector

Return on

Equity(ROE)

Net income/Common

stock + Retained

Earnings 12.30% 15.60% 17.51% 17.99%

ROE

ROE shows the amount of net income returned as a percentage of the shareholders equity. In

other words, indicates how much profit a company generates with the money that

shareholders have invested.At 31st of March 2011 the ROE has increased to 15.6% mainly

due to the increase in the net income.Even though the figure for Carclo is lower that its peer’s

average and the sector, Carclo appears to generate sufficient returns to its shareholders.

3.5 Shareholders’ Ratios

In assessing the shareholder value creating by the company, it has employed two

approaches:the market value ratios and the Economic Value Added (EVA).The table 3.5.

presents the market value ratios.

Table 3.5. Market value ratios

Ratios Formula 2010 2011

Peers

Average Sector

Price/Earnings

Ratio (P/E)

Price per

share/Earnings

per share 28.8 times 29.7 times 18.7 times 14.26 times

Price/Book Ratio

Price per

share/Equity

book value per

share3 2.58 times 3.2 times 4.96 times 1.89 times

Price/Earnings (P/E) Ratio

3 The equity book value per share is obtained by dividing the total equity by number of shares in issue.

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P/E is an evaluation ratio of a company's current share price compared to its earnings per

share.The ratio in 2011 is 29.7 which mean that shareholders are willing to pay £29.7 for £1

of reported earnings. Comparing to its competitors, investors are willing to pay more for

Carclo Plc for every pound of earnings compared to industry (14.26) and its peer’s ratio as

well (18.7).

Price/ Book Ratio

This ratio shows the relation between the market value of a share and the book value per

share of the reported equity on the balance sheet. The price-to-book ratio of Carclo appears

lower that its peer’s average, while comparing to the sector figure Carclo has higher P/B

ratio. In general, a figure greater than 1 (such as Carclo’s figures) implies that the shares are

more valuable that what the shareholders originally paid.

Economic Value Added (EVA)

EVA attempts to measure the economic profit of the firm rather than the accounting profit by

considering the firm’s cost of capital. The calculation formula of EVA is presented below.

EVA = (r-k) × A= (5.2%-9.59%) × 116,181,000= -£ 5,100,345.9

Where r = Operating return on assets; k = Total cost of capital; A = Amount of capital (or

total assets).

EVA is a negative figure because the operating return on assets is lower than the cost of

capital, and thus the firm earns a lower return on capital than the investors’ required rate of

return. Comparing to its peers, Carclo in general appears to be in better economic position

since the peers average is (-£82 m).

Overall, given the size of the firm and the current economic recession, Carclo showed a slight

improvement in its financial indicators during 2011; however it is suggested that management

should take action to manage more effectively its resources, improve its sales and thus creates

higher profit margins.

3.6. Limitations of Ratio Analysis

The use of financial ratios is indicative when it comes with the assessment of firm

performance. However, there are some limitations that should be mentioned. Firstly, they are

only approximations and may not truly reflect their performance. Another limitation is the

fact that the companies within its peer and industry groups may employ different accounting

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and financing policies. Additionally, it is based on historical financial figures that do not

usually consider other parameters such as the inflation and interest rates. Finally, the analysis

is based only on financial data, ignoring other non financial information which would be of

the same importance for the company.

18

IV. Risk Analysis

In order to analyse the risk profile of Carclo Plc, a regression analysis using SPSS was

employed. Particularly, the stock returns regressed against the market returns by using a five

years dataset of historical monthly share prices and annual dividends of the company and the

Small Cap Index. The estimation period is from December 2006 to November 2011 and all

the share prices were retrieved from the Carclo’s official website. Then, using the results

from the regression, an analysis of company’s cost of capital (equity and debt) is presented

based on the Capital Asset Pricing Model (CAPM). The stock return (Rj) and the market

return (Rm) were calculated by using the following formulas:

�� ��������� �� �����

���� (4.1) and �� �

�������

���� (4.2) where Pt is the share price at the

beginning, Pt-1 the ending share price of the interval and D is the dividend paid for the

period.

4.1. Risk Profile

The results of the regression are depicted in the following table.

Table 4.1.Regression Output

R square (R2) 0.267

Beta (β) 0.813

Intercept (α) -0.21

The R-squared (R2) indicates that 26.7% of the company’s risk can be attributed to market

risk. This type of risk also called systematic or non diversifiable risk because it is linked to

macroeconomic factors (such as the inflation and interest rates) and thus it cannot be easily

diversified away. The remained proportion of the risk is 73.3% (1- R2), which can be

attributed to firm specific factors and it can be considered as diversifiable risk. Since the

systematic risk cannot be diversified away, the investors should be rewarded with returns on

shares for bearing this systematic risk. Therefore, the higher the systematic risk for a firm, the

higher the return that investors require. The following chart summarises the source of risk for

Carclo Plc.

19

Additionally, the regression analysis showed a slope coefficient of 0.813, which reflects the

market beta. This figure explains the relationship between stock return and market risk and in

this case shows that the volatility of the Carclo’s shares is 0.813 times as large as that for the

Small Cap Index as a whole. In addition, the fact that the beta is lower than 1 means that the

company has less systematic risk than the market (Moles et al., 2011). However, since the

beta from the regression considers only the market risk, tends to underestimate the cost of

equity as the investors are exposed to different types of risks. For this reason it is essential to

adjust the market beta in order to reflect the total risk faced. The total beta is given by the

equation 4.3., and gives a total beta of 1.57.

����� ���� �� ����� ���� � � �! � " �

√$%&' � � = 0.813/√0.267= 1.57 (4.3)

The total beta of 1.57 represents all the risks that investors are likely to face when they invest

in Carclo shares. When compared with the average sector beta (1.27)4, Carclo’s investors

appear to face higher risk. However, the higher beta-risk of Carclo Plc offering the possibility

of higher returns to the investors. It is worth to mention that a factor that affects the level of

beta is the type of business. Specialty Chemicals sector is characterised as cyclical (i.e.

affected from the economic conditions) and other things remained equal, cyclical firms

expected to have higher betas that non cyclical firms (Damodaran, 2009).

4 Obtained from Reuters.

Market risk

26.7%

Firm specific

risk

73.3%

Chart 4.1 Source of Risk

20

4.2. Performance Profile

Jensen’s Alpha

The intercept of the regression provides a measure of performance during the regression

period. Using the formula of the CAPM the Jensen’s alpha, which is the difference between

the intercept and the Rf (1-β) can be established. Analytically:

�� � �1 2 3��� 4 �1� =5 �� � �1�1 4 3� 2 3�� =5

�� � � 2 3�� (4.4. Regression Equation)

Where: Rj- stock return, Rm- market return, Rf - risk free rate, α -intercept, 3-slope of the

regression.

The performance of the company is expressed by the Jensen’s alpha which is the difference

between the intercept (α) and the Rf (1-β), For the calculations, we consider as the risk free

rate (Rf) the UK 10-years governmental bonds, which is 3.75% (Bloomberg, 2011) and the

UK has no default risk spread (NYU, 2011). Analytically, the Rf(1-β) equals to 3.75%% (1-

0.813) = 0.70%, while the intercept given in the table 4.1., is -0.21%.Therefore α6 Rf (1-β)

and the difference between α and Rf (1-β) equals to [(-0.21%) – 0.70%] = - 0.91%.

Consequently, the Jensen’s alpha is negative and means that the Carclo’s shares perform

worse than expected during the regression period. In other words, Carclo did 0.91% worse

than expected between 2006 and 2011. In this point, one can reasonably assume that a great

bear of this negative performance is held by the management; however the cause of the

underperformance can be attributed to the sector performance as well.

Risk Mix

In order to determine the proportion of the risk attributable to the business factors and to the

financial leverage of the firm, it is essential to calculate the unlevered beta which is given by

the equation 4.5.

78 �9:

��������;<� = 1.57/1+ (1-0.28)(0.3) =1.29 (4.5)

21

Where: βl is the levered beta(1.57), t is the corporate tax rate (28%)5, D/E is the debt to

equity ratio and equals to 0.3, where D6 is market value of debt and E

7 is the market value of

equity.

Considering the levered beta of 1.57 and the unlevered beta of 1.29, it can be estimated that

the 82%8 of the risk can be attributed to business risk and the remained 18% of risk arising

from the financial leverage of the firm. The company has lower financial leverage risk which

can be explained by the fact that the company has mainly financed its activities by employing

equity instead of debt.

4.3. Expected Return on Equity and Cost of Equity

In order to estimate the expected return on an equity investment to equity investors of Carclo

Plc, the formula provided by the CAPM model will be applied. The formula is as follows:

=�>� � ?@ 2 A B �?C-Rf) (4.6)

Where (Rf) risk free rate is 3.75% and beta is 1.57 as mentioned above. The risk premium is

expressed by (Rm-Rf) and for the UK is 5%, according to the risk premiums data provided

from the NYU (updated in July 2011).Thus, according to the formula the expected return

equals to [3.75% +1.57(5%)] = 11.6%.

The above formula depicts clearly that the expected rate of return has a positive relationship

with the beta of the firm and the risk premium. Since the higher beta and the higher risk

premium imply a higher risk, we anticipate that the expected rate of return would be higher

for the riskier firms. Comparing Carclo’s cost of equity with its peer’s average (12.64%) and

betas (1.78), the company appears to face lower risk than its peers and thus its returns to

investors are expected to be lower.

From investors’ standpoint, the expected return on equity reflects the rate that they require for

the risk that they have taken in order to invest in the equity of the firm. In Carclo’s case, the

return is 11.6% and indicates the premium that investors demand for holding Carclo’s shares

given its risk in comparison to the risk-free securities. From a financial management

standpoint, this rate should be taken into consideration during firm’s project appraisals since

it express the minimum hurdle rate that determines whether to invest in a project. In other

words, this return expresses the return that investors require in order to break even with their

5 The tax rate is given in the company’s annual report, 2011.

6 The market value of debt is £ 53,706,578 (see section 4.5 for the calculation).

7 The market value of equity is given by multiplying the number of shares by the share price (61,561,702 × 283

p = £174,219,616.7) 8 1.29/1.57=0.82 or 82%

22

equity investments (Damodaran, 2006), and thus managers need to use it as a benchmark rate

for investment analysis. Therefore, the expected return on equity is the cost of equity to the

firm.

4.4. Cost of Debt

The cost of debt expresses the current cost to the firm of borrowing funds to finance projects.

Since Carclo has not rated from a rating agency, for the purpose of this analysis an estimation

of synthetic rating should be employed based on its interest coverage financial ratio. The

interest coverage ratio as presented in the Table 3.3. is 10.5, which according to the synthetic

rating estimations of NYU (2011), the company gets an AA rating with a default spread

equals to 0,50%. Notice that the risk free rate is 3.75% as mentioned in the previous section.

According to Damodaran (2006) the Pre-tax cost of debt equals to Risk free Rate + Default

Spread. Therefore, the Pre-tax cost of debt for Carclo is 3.75% +0.5% = 4.25%.

Since the debt is tax deductable, the After-tax cost of debt equals to:

Pre-tax cost of debt x (1-t) which is 4.25% x (1-0.28) = 3.06%.

4.5. Cost of Capital

The total capital for a firm is the value of its equity plus the cost of its debt. In order to

measure the cost of capital of the firm, the Weighted Average Cost of Capital (WACC)

formula is used. According to this formula the cost of capital is the weighted average of the

costs of different components of financing (i.e. debt and equity), with the weights based on

their market values. The formula is as follows:

DEFF � �� G H

�H2 �I

�H (4.6)

Where ke is the cost of equity (11.6%), kd is the cost of debt (3.06%), E is market value of

equity9 (£ 174,219,616.7) and D is the market value of debt (£ 53,706,578).

Before proceeding with the calculation of the WACC, it would be critical to show the

estimation of the market value of debt.

9 The market value of equity is given by multiplying the number of shares by the share price (61,561,702 × 283

p)

23

According to balance sheet, the firm has only non-traded debts. The list below presents the

different categories of debts given in the group balance sheet along with their years to

maturity.

• Bank Overdrafts: £11,148,000 (1 year)

• Bank loan: £19,002,000 (1-2 years)

• Retirement obligations: £9,067,000 (2- 5 years)

• Trade payables and other creditors: £15,551,000(up to1 year)

Thus the book value of debts as at 31st of March 2011 is £54,768,000. A method to obtain the

market value of debt is to treat the debt as a coupon bond, with a coupon equals to interest

expenses of the debts and a maturity equals to the average maturity of the debt. The interest

expenses is £582,000 (given in the annual report) and since the majority of the debt has

maturity close to one year (as depicted above), for the purpose of this analysis the one year

was taken as the average maturity for the debt. The following formula which is used to

evaluate bonds will be employed to measure the market value of debts.

Market value (MV) of debts = Ix PVIFA + �

���!�J (4.7)

Where I- the interest expenses, PVIFA-Present Value Interest Factor of Annuity, M- the book

value of the total debt ,k – the cost of debt and n-years to maturity.

Analytically, MV of debt = 582,000 x 0.9710

+ 54,768,000/(1+0,0306) = £ 53,706,578.

It is apparent that the MV of debt is lower that its book value, which can be attributed to the

continuous changes in the market.

Given that we have estimate the market values of both debt and equity, the weights of debt

and equity are as follows:

Debt ratio =

�H =

KL,NOP,KNQ

KL,NOP,KNQ��NR,S�T,P�P.N = 0.235or 23.5% (4.8)

Equity ratio =H

�H =

�NR,S�T,P�P.N

�NR,S�T,P�P.N�KL,NOP,KNQ = 0.765 or 76.5% (4.9)

Hence, the weight of equity for the company is 76.5% while its debt weight is 23.5%. This

indicates that the firm uses a higher percentage of equity to finance its operations in

comparison to its debt contribution.

At this point and since we have estimate all the parameters that the equation (4.6) of WACC

requires, the cost of capital of Carclo Plc is as follows:

10 PVIFA =

��U

�UVW�

! =

��U

U.XYXZ

O.OLOP = 0.97

24

WACC= 11.6% x 0.765 + 3.06% x 0.235 = 8.87% + 0.72% = 9.59%

Notably the cost of capital is lower than the cost of equity, which is a general rule according

to Damodaran (2006). Similarly to the cost of equity, the cost of capital express the minimum

acceptable hurdle rate that will be used by managers to determine whether to invest in a

project. In other words, the cost of capital is the expected rate of return demanded by a firm’s

investors for investing in the firm, and thus the higher the rate of return demanded by a

firm’s investors for the capital they provide to the firm, the more costly it is for a firm to

finance itself (Sharfman and Fernando ,2011).

25

V. Capital Structure Analysis

The capital structure shows how a firm finances its overall operations by using different

sources of funds (i.e. debt and/or equity). The following section will analyse Carclo’s sources

of financing and discuss the trade off on debt versus equity.

5.1. Sources of Financing

Carclo Plc uses both debt and equity in order to fund its activities. The following table

depicts the financing sources of the firm as at the 31st of March 2011.

Table 5.1. Financing Sources

Sources Book Value (£000)

Long Term Debt

Bank loan 19,002

Retirement obligations 9,067

Short Term Debt

Trade payables and other

creditors 15,551

Bank Overdrafts 11,148

Equity 54,768

Ordinary shares 3,078

Retained Earnings 34,746

Other 16,057

Total 109,099

According to the table 5.1 the group has a medium term bank loan (one to two years) with

interest rate of 0.7% above LIBOR. This medium term bank loan is comprised by multi-

currency loan facilities and it has been separated equally between the group’s two principal

UK bankers. These credit facilities are due for renewal in 2012 and discussions with the

banks have already started. The bank loans are secured by guarantees from certain group

companies and by fixed and floating charges. Specifically, the group’s lending banks hold

security over the current assets of its three main UK trading subsidiaries.

Additionally, the group operates a defined benefit pension scheme and also makes payments

into defined contribution schemes for employees. This scheme comprises of asset

investments, and according to annual report (pp.56) the benefit scheme is closed to new

entrants.

The bank overdrafts are predominantly in sterling and bear interest at two percent above the

prevailing UK bank base rates. The overdraft facilities are due for renewal in early 2012. In

26

addition the group has other financial instruments such as trade payables and other creditors

which arise directly from its operational activities. Apparently, the group meets its day to day

working capital requirements through short term facilities such as overdrafts.

The group’s equity mainly consists of ordinary shares, retained earnings and other reserves

and premiums. The following chart depicts the funding choices of Carclo as percentages of

its total capital structure.

From the chart 5.1 it is obvious that the main funding source for Carclo is retained earnings

(31.85%) while the short term debt (overdrafts and other creditors) covers approximately the

25 % of its total capital structure. Notably, ordinary shares cover a low proportion, which can

be attributed to the fact that the cost of equity is higher than the cost of debt11

. Thus it can be

said that the funding hierarchy of the company is consistent with the arguments of pecking

order theory (see, for example, Myers, 1984). The lower debt to capital ratio (23.5%)

compared to equity to capital ratio (76.5%) provides additional support regarding the funding

mix of the company. The company uses more inside equity (retained earnings) which is less

risky than raise funds through the market, while the relatively low debt ratio (23.5%)

indicates that the firm and its shareholders face lower financial risk.

11

Cost of debt is 3.06% while cost of equity is 11.6% (see section 4).

Bank loan

17.42% Retirement

obligations

8.31%

Trade creditors

14.25%

Bank Overdrafts

10.22%

Ordinary

shares2.82%

Retained

Earnings

31.85%

Other equity

sources

14.72%

Chart 5.1 Capital structure

27

5.2. Trade off on Debt versus Equity

Since different types of financing comprise risk and costs, managers strive to identify the mix

of debt and equity that minimises these costs. Based on trade off theory, managers choose a

specific target of capital structure by assessing the costs and the benefits of debt.

5.2.1 Benefits of Debt

5.2.1.1. Tax advantage

One main benefit of debt relatively to equity is that the interest paid on debt is tax deductable

whereas dividends are not. This fact makes debt a more attractive choice to managers. Since

the marginal tax rate of Carclo is 28% and the interest payment of the group for the year

ended 31st March 2011 has been £582,000, the company tax benefit has been £162,960.

Consequently, this tax shield adds to the total value of the firm. Indeed, MacKie-Mason

(1990) in his study found that the desirability of debt finance varies positively with the

marginal tax rate and that changes in the marginal rate for any firm should affect financing

choices. Another, benefit of debt is that it is less expensive than equity and this can be

depicted by the fact that the cost of debt for Carclo is smaller than its cost of equity (3.06%

versus 11.6%).

5.2.1.2. Adds discipline to managers

Carclo uses retained earnings as its main funding source, which allows managers not to be

burdened extensively with debt and other external funding. However, this may lead managers

to consider projects in their merits rather than considering shareholders’ interests and

maximizing their wealth. In this context, debt can benefit shareholders by providing

managers with incentives to maximize the cash flows produced by the firm and ensure that

the investments they make will earn at least enough return to cover the interest expenses.

Furthermore, Jensen (1986) advocates that debt can be beneficial to managers since by

paying debt’s interests, the amount of cash under the managerial control is reduced. This

shortage of cash motivates managers to seek more profitable projects with positives NPV’s.

Denis and Denis (1993) in their study found that firms that increase debt, they report

increased ROE. According to the table 3.4, the group has ROE of 15.6% which is smaller

28

than its competitors and the sector figure (17.51%). Thus, the company appears to have low

ROE and additional will enhance its performance and shareholders’ value.

5.2.2. Costs of Debt

5.2.2.1. Bankruptcy costs

The expected bankruptcy costs contain two variables: the probability of bankruptcy and the

cost of going bankrupt (directly and indirectly). Direct costs includes the legal and

administrative costs of a bankruptcy, while indirect costs arising from the perception that

borrowing may leads to financial distress which in turns affects the sales and the capacity to

raise credit. Furthermore, borrowing money can expose the firm to default risk and the

likelihood that the cash flows will be insufficient to meet its debt obligations. Carclo Plc

interest coverage ratio is 10.5 times (see table 3.3) which suggests that the firm has sufficient

earnings to cover its interest payments. Finally since the company uses more equity than debt

to finance its operations and has a relatively low debt to capital ratio (23.5%), the company

does not appear to face immediate financial distress.

5.2.2.2. Agency costs

Debt agency costs problem arises from the conflict between shareholders and creditors under

the assumption that managers serve shareholder’s best interest. A conflict occurs when

managers adopt investment decisions that increase shareholders interest, while at the same

time the interest of creditors may decrease (Jensen and Smith, 1985). For instance, managers

and shareholders may use the borrowings in riskier projects than the creditors want or might

pay themselves large dividends rather than investing the cash in the business.Moreover,

Jensen and Meckling (1976) report two other agency costs related to debt. The monitoring

and bonding cost among creditors and managers which arise from the controls and

restrictions of managerial actions that bondholders impose in order to assure their interests

and the restructuring and bankruptcy costs (i.e. the cost of establishing corporate rules and

mechanisms for the firm to avoid incapability of satisfying its obligations). Negotiations

again the existing debt contracts could reduce and discourage the presence of conflict

between shareholders and bondholders. Notably, Carclo has already started discussions to

renew and renegotiate its bank loan in 2012, while an interest rate of 0.7% above LIBOR may

be an indication of compensation for monitoring cost incurred by lenders. Finally, according

to Damodaran (2006), the agency conflict increases when shareholders and creditors do not

29

have visibility on the company’s investment, such as investments in intangible assets.

Carclo’s intangible assets consist the 31% of its total assets, which implies high agency costs,

since the company has invested in new platform technologies.

2.2.3. Loss of financing flexibility

Future financial Flexibility is critical for every company since it allows firms to take

advantage of unforeseen investment projects which may bring considerable cash flows into

the form. Generally, when a firm borrows closely to its capacity, it is more likely to lose the

flexibility of financing future projects with debt. The high debt will burden the firm in the

future and may create high credit risks and illiquidity problems. However, Carclo has

relatively low debt to capital ratio (23.5%) and high interest coverage ratio (10.5%),which

both indicates that the group is not up to its borrow capacity. Additionally, the group has

undertaken control measures to secure the risk arising from the debt. Specifically, the group

manages liquidity risk by maintaining a mixture of long term loan and short term overdraft

facilities which have been established to ensure that adequate funding is available to fund its

operational and investment activities. Finally, one key measure to assess the flexibility of the

firm is its access to the capital markets. That means that Carclo can always raise funds from

the market, however since the Carclo is a small company (Small Cap), with less growth

opportunities compared to bigger firms, it is suggested that should value its flexibility more

carefully.

Overall, it can be concluded that Carclo’s capital structure is consistent with the arguments of

pecking order theory. Myers (1984) states that firm’s funding decisions made by following a

specific order. The first choice is to use internal available funds (e.g. retained earnings). After

that, the firm will start relying in external funds such as debt and equity following an

ascending order from the safer choice to the riskier. This choice of retained earnings does not

expose the firm and its shareholders in high financial leverage risk and provides greater

financial flexibility. Moreover, the trade off theory of the costs and benefits of debt versus the

equity facilitates the managers to choose a specific target of capital structure by assessing the

costs and benefits of debt. Apparently, when marginal benefits of debt exceed its marginal

costs then the firm is advised to borrow money.

30

VI. Conclusion

The above analysis aims to critically evaluate the corporate governance, performance, risk

profile, and capital structure of Carclo plc.

The governance structure of the Carclo Plc appears to correspond with the recommendations

of the Combined Code in relation to the board independence and composition and its board

appears efficient and effective enough to fulfil its fiduciary responsibilities and maximize

shareholders’ wealth. Carclo’s ownership structure suggests that the majority of company’s

shares are held by minority shareholders, which suggesting the separation of ownership and

management and thus the existence of agency problems.

In terms of performance, Carclo showed a slight improvement in its financial indicators

between 2010 and 2011; however it is suggested that management should take action to

manage more effectively its resources, improve its sales and thus creates higher profit

margins. Encouragingly, the last years Carclo has invested in new technologies which

expected to bring future cash flows in the company.

Furthermore, the risk analysis part shows that Carclo has higher beta the sector average,

while based on Jensen’s Alpha, the company’s shares perform worse than expected during

the regression period. Therefore the management should take action to improve its share

performance and increase their trading volume.

Finally, in terms of capital structure company’s funding choices are consistent with the

pecking order theory. Carclo uses more inside equity (retained earnings) than external debt as

a source of funding. This choice provides to the company greater financial flexibility and

lower bankruptcy costs. The debt comes second in funding hierarchy since it is less expensive

that equity.

31

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