FIN4505: CORPORATE FINANCE COURSEWORK

Module leader: Dr. Ngoc Nguyen Student: Stela Chatzinaki (M00340250) London, January 20th, 2012

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

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 Carclos 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 companys risk profile, while the study continues by analysing the capital structure of the firm. Finally, the study ends with a recommendation and conclusion section.

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 nonexecutive director of the Suprajit Engineering Limited in India. This previous experience as a CEO along with the 16 years experience as Carclos 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 CEOs 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 CEOs 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.

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 Carclos 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 Carclos 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 Chairman Christopher Ross Executive Directors Ian Williamson Robert Brooksbank Non-Executive Directors Michael Derbyshire Bill Tame Appointment Date Age Salary (000) 69 237 138 Benefits (000) 12 12 Ordinary Shares (Units) 81,500 687,823 185,450

1 January 2006 1 July 1995 1 April 2004

66 60 45

1 January 2006 1 January 2006

63 56

28 28

40,000 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
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According to the Combined Code, companies below the FTSE 350 Index considered as small.

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, Carclos 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, Carclos 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 firms 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 analysts information provided in Carclos website, three analysts are currently following the company: the Brewin Dolphin, Charles

Stanley and Arden Partners. In order to examine how widely Carclos 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. Chart 2.1 Share Trading Volume of 2011
2500000 2000000 1500000 1000000 500000 0

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 Carclos shares was higher compared to other years and according to the detailed share information given in the Carclos 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
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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, Carclos 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 groups 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 companys 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. Figure 2.3. Category of Shareholders
Institutions 2% 14% Directors Other

84%

Source: Carclos annual report, 2011.

As mentioned above, the directors hold 2% of the total shares of the company and it is worth to mention that during the financial year ends at 31st March 2011, the CEO increased his shares by 20,000.Besides 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 2.2. Holdings Insiders Units held 7,782,850 Ruffer LLP 5,987,591 Henderson Global Investors 4,457,136 Schroder Investment Management 4,018,689 J P Morgan Asset Management Standard Life Investments 3,075,359 Directors 1,341,773 Total Insider Holdings 26,663,398
Source: Carclos annual report, 2011.

% Shares 12,64 9,73 7,24 6,53 4,992 2,00 43,13

As the table illustrates, the major shareholders, apart from the directors, are mainly asset and investment management institutions. institutions The total percentage of insiders is 43.13% and thus the remaining 56.87% is held by outsiders, who in this case involves individual shareholders and other institutions with small amount of shares held. Thus, Carclos ownership structure suggests that the majority of companys shares are held by minority shareholders who may
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In this analysis is considered as insider ( 4.99% is close to 5% and their difference is insignificant).

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 Carclos 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 firms performance, it is important to compare the companys ratios with its peers figures and sector figures retrieved from Reuters 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 companys ability to cover its short term obligations when they fall due.
Table 3.1 Liquidity ratios Ratios Approach 1
Current Assets/Current Liabilities Cash and accounts receivable/Curre nt liabilities Accounts receivable/(Annu al credit sales/365) Cost of goods sold/Inventory

Formula

2010

2011

Peers Average

Sector

Current ratio

1.74

1.48

2.06

1.76

Quick ratio

1.3

1.04

1.36

1.27

Approach 2
Aver. Collection period Inventory Turnover

91.82 days or 3.98 times 7.35 times or 49.6 days

77.54 days or 4.71 times 6.7 times or 54.46 days

54.43 days or 7.58 times 7.89 times or 92.32 days

8.09 times 6.03 times

Current ratio The current ratio compares the current assets with current liabilities and depicts the companys 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 peers 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). Carclos 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. Carclos quick ratio is close to its peers 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 peers 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 inventorys 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 firms ability to generate earnings as compared to its assets.
Table 3.2.Profitability ratios Ratios
Operating Return on Assets Operating Profit Margin Total Assets Turnover FixedAssets Turnover

Formula
Operating return/Total assets Operating profit/Sales Sales/Total assets Sales/Fixed assets

2010

2011

Peers Average

Sector

4.9% 6.8%

5.2% 7%

12.69% 14.36% 1.42 times 2.52 times

12.20% 13.66% 1.15 times N/A

0.72 times 0.76 times 1.15 1.2

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%), Carclos figures are far too low which indicate that the managers did not manage their assets effectively. From an investors 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.Carclos 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 companys 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 Peers Formula 2010 2011 Average Total debt/Total assets 60% 53% 48.5%
Operating income/Interest

Ratios Debt Ratio Times Interest Earned

Sector
N/A

11.4 times

10.5 times 9.29 times

0.66 times

Debt to Assets ratio This ratio shows what proportion of firms assets is being financed through debt. Particularly, Carclos 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 firms 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. Carclos ratio appears to be slightly over its peers 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
Return on Equity(ROE)

Formula Net income/Common stock + Retained Earnings

2010

2011

Peers Average

Sector

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 peers 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

Price/Earnings Ratio (P/E)

Price/Book Ratio

Formula Price per share/Earnings per share Price per share/Equity book value per share3

2010

2011

Peers Average

Sector

28.8 times

29.7 times

18.7 times

14.26 times

2.58 times

3.2 times

4.96 times

1.89 times

Price/Earnings (P/E) Ratio

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 peers 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 peers average, while comparing to the sector figure Carclo has higher P/B ratio. In general, a figure greater than 1 (such as Carclos 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 firms 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.

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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 Carclos official website. Then, using the results from the regression, an analysis of companys 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) Beta () Intercept () 0.267 0.813 -0.21

The R-squared (R2) indicates that 26.7% of the companys 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.

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Chart 4.1 Source of Risk

Market risk 26.7% Firm specific risk 73.3%

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 Carclos 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, Carclos 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).

Obtained from Reuters.

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4.2. Performance Profile

Jensens Alpha The intercept of the regression provides a measure of performance during the regression period. Using the formula of the CAPM the Jensens alpha, which is the difference between the intercept and the Rf (1-) can be established. Analytically: = 1 = (4.4. Regression Equation) Where: Rj- stock return, Rm- market return, Rf - risk free rate, -intercept, -slope of the regression. The performance of the company is expressed by the Jensens alpha which is the difference between the intercept () and the Rf (1-), 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-) equals to 3.75%% (10.813) = 0.70%, while the intercept given in the table 4.1., is -0.21%.Therefore Rf (1-) and the difference between and Rf (1-) equals to [(-0.21%) 0.70%] = - 0.91%. Consequently, the Jensens alpha is negative and means that the Carclos 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.

= 1.57/1+ (1-0.28)(0.3) =1.29

(4.5)

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Where: l 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 E7 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: -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 Carclos cost of equity with its peers 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 Carclos case, the return is 11.6% and indicates the premium that investors demand for holding Carclos shares given its risk in comparison to the risk-free securities. From a financial management standpoint, this rate should be taken into consideration during firms 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 6

The tax rate is given in the companys annual report, 2011. 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%

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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:

(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.

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

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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 +

(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 =

,, ,,,,. ,,.

= 0.235or 23.5% (4.8) = 0.765 or 76.5% (4.9)

Equity ratio =

,,.,,

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 =

= 0.97
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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 firms investors for investing in the firm, and thus the higher the rate of return demanded by a firms investors for the capital they provide to the firm, the more costly it is for a firm to finance itself (Sharfman and Fernando ,2011).

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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 Carclos 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 Long Term Debt Book Value (000) 19,002 9,067 15,551 11,148 54,768 3,078 34,746 16,057 109,099

Bank loan Retirement obligations

Short Term Debt

Trade payables and other creditors Bank Overdrafts

Equity Ordinary shares Retained Earnings Other Total

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 multicurrency loan facilities and it has been separated equally between the groups 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 groups 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
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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 groups 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.

Chart 5.1 Capital structure

Other equity sources 14.72% Bank loan 17.42% Retirement obligations 8.31%

Retained Earnings 31.85%

Trade creditors 14.25% Bank Overdrafts 10.22%

Ordinary shares2.82%

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).

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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 debts interests, the amount of cash under the managerial control is reduced. This shortage of cash motivates managers to seek more profitable projects with positives NPVs. 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
27

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 shareholders 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
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have visibility on the companys investment, such as investments in intangible assets. Carclos 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 Carclos capital structure is consistent with the arguments of pecking order theory. Myers (1984) states that firms 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.

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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. Carclos ownership structure suggests that the majority of companys 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 Jensens Alpha, the companys 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 companys 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.

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