Raid Mutter Bangor University

MBA Banking & Finance International Financial Markets

Contents

Page

1
Introduction 2
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2
Raising capital 2
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3 The Capital Asset Pricing Module (CAPM) and the

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- Cost of Capital

4
The Cost of Capital 5
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5
(Capital Asset Pricing Module (CAPM 6
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6
The relevance of CAPM to the Cost of Capital 6
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7
Conclusion 7
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8
References 8
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Raid Mutter Bangor University
MBA Banking & Finance International Financial Markets

:Introduction

This paperwork is written to explain how Large Companies raise

capital from the equity and bonds markets and to discuss the
relevance of capital asset pricing model (CAPM) to a company
evaluating its Cost of Capital. Therefore, it will start with explaining
the methods of issuing stocks and bonds. Then, it will move to
explaining what is meant by Cost of Capital and CAPM in order to
discuss the relevance CAPM to a company seeking to evaluate its
.cost of capital

:Raising capital
It is well clear that large corporations could not have grown to their
present size without being able to find innovative ways to raise
capital. Corporations have different methods for obtaining that
money to expand and finance their projects. These methods mainly
include Issuing Stocks and bonds, borrowing and increasing their
capital by using profits they gained as described by Conte, C. &
Carr, A. (2008). For the purpose of this paperwork, only issuing
:stocks and bonds will be explained as follows

Issuing stocks (shares) is a common way of raising capital from the

equity market. This could be done by listing in an exchange market
.such as the London Stock Exchange

Cuthbertson, K. and Nitzsche, D. (2008) discussed these shares as

they could be Ordinary shares1 or Preference shares2. The issuance
could be by the Initial Public Offering (IPO), where the company is

Ordinary shares make their holders the owners of the company with a residual 1
(claim on its profits as described by Cuthbertson, K. and Nitzsche, D. (2008

Preference shares have some characteristics fo ordinary shares and some of 2

debt instrument such as their holders have a claim on dividends that takes
preference over ordinary shareholders dividend and if the firm goes into liquidity,
payments ot preference shareholders are paid before ordinary shareholders as
(stated by Cuthbertson, K. and Nitzsche, D. (2008

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Raid Mutter Bangor University
MBA Banking & Finance International Financial Markets

offering its shares for the first time in public, or by Sesoned Equity
Offering, where the company need to raise more fund after the IPO
.(as highlighted by Cuthbertson, K. and Nitzsche, D. (2008

The process of issuing these shares is a long and a complicated one.

Guidance on that process are available such as the "A Practical
Guide on Listing" which is published by London Stock Exchange.
This guide describes the process of issuing stocks (or listing) in
:three main stages as follows

The Decision Stage, the Flotation Process stage and the Life as a
Public Company stage where the company has already raised the
capital it needs and it is not going to be discussed as it is not part of
.the purpose of this paperwork

The decision stage is basically the stage where the company need
to look at itself and decide if it is right for listing, are the company
mangers ready for listing and finally, when its agreed on listing,
preparing its way for flotation by appointment of the advisors for the
process, choosing the method of listing, executing necessary
changes to its board and operations and beginning the valuation
.process

The flotation process, which is the main step for this paperwork, is
the second and most important stage. The first step of this stage is
to choose good quality advisors such as the sponsor, the Corporate
Broker, the Reporting Accountant, the Lawyers and maybe others
such as financial public relations consultants to help with increasing
the public awareness of the company. This is very important as they
will be the expertise advising the company in all stages. The
sponsor, or the underwriter, takes a fundamental responsibility in
the flotation process and gives advices to the company on different
issues and probably advice on the appointment of other professional
advisers. Therefore, agreement between the company and the
sponsor is very important and usually meeting are held between the

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Raid Mutter Bangor University
MBA Banking & Finance International Financial Markets

two parties in order to introduce each other and agree on how to list
the company. The sponsor role could be played by an investment
bank, stockbroker or other adviser such s a corporate finance house
or accountancy firm as long as they are approved by the local
.authority such as the UKLA in the UK
The underwriter expect a fee for doing his duties which is around
1.5 – 2 % or they could enter into a "firm commitment" where
they buy the securities from the company at an agreed price and
then sell them at a higher price and make their profits as stated by
.(Cuthbertson, K. and Nitzsche, D. (2008

The Corporate Broker is usually agreed on by both the company and

the sponsor and plays a major role in assessing the current
conditions in the stock market, and provide vital feedback on
.investors who would likely response to the issuance

Two sets of Lawyers are assigned to ensure that the listing process
is legal, one to advise the company and its existing shareholders,
.and the other to advise the sponsor

The second step in the flotation stage is to prepare the prospectus

or listing particular by the company and its advisors. This document
is vital to the flotation, and mainly it sets out all the information
which has to be made public to investors under the UKLA’s Listing
Rules, as well as, it plays a critical aspect for the company itself,
amounting to a coherent description of the business, its areas of
activity and its prospects. The quality of this document is vital as it
plays a fundamental impact on the success of the company
flotation. This document, along with other important, such as the
underwriting or placing agreement, directors’ service contracts,
audited accounts and all reports referred to in the prospectus
documents have to be submitted for approval by the assigned local
authority, such as the UKLA in the UK prior to the announcement of
.the company flotation and the price of shares

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Raid Mutter Bangor University
MBA Banking & Finance International Financial Markets

Then, Applications for listing and trading are submitted to the local
authority, such as the UKLA in the UK and, at the same time, formal
application for admission to trading is submitted to the Exchange.
This, then lead to the admission week where the applications and
cash from prospective investors are received and the share
application lists are closed. After this week, shares are admitted,
.and shares are traded publicly on the main market

On the other hand, issuing Bonds is an alternative way of raising

capital as discussed earlier. According to Cuthbertson, K. and
Nitzsche, D. (2008) bonds are a way of obtaining a large amount of
cash up front in return for a promise to pay a stream of cash flows
(the coupons) in the future until the maturity date of the bond with
fixed or variable interest rate and this can be domestic or
international in a foreign currency where the US has by far the most
.active corporate bond market
Cuthbertson, K. and Nitzsche, D. (2008) describes the process of
issuing Corporate Bonds as procedure as a similar one to the
issuance of stock and in this process, the issuance must be
approved by the board of directors and maybe by stockholders vote
and often a registration statement is expected to be issued to the
regulatory authorities such as the Securities & Exchange
Commission in the US. This statement contains an indenture or deed
of trust3, which is a written agreement between the bond issuer and
a trust company. Cuthbertson, K. and Nitzsche, D. (2008) lists the
points to be covered by the indenture as "the cash term in the bond
(amount of issue, par value of each bond, coupon rate, maturity
date, etc), collateral protecting the bondholder, sinking fund
arrangements, protective covenants and convertible and call
.elements
Yalden, R et al (2008) stated that "it is the invariable practice of companies 3
issuing bonds, debentures, notes or other obligations for sale to the public to
issue such obligation under a formal trust document known variously as a trust
"deed, a trust indenture, a note indenture or the like

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Raid Mutter Bangor University
MBA Banking & Finance International Financial Markets

The Capital Asset Pricing Module (CAPM) and the Cost of

:Capital

To discuss the relevance of CAPM to a company seeking to evaluate

its Cost of Capital, we firstly need to understand what CAPM and
Cost of Capital mean and why do companies evaluate their cost of
capital? But, for the purpose of this work, it would be better to start
with describing the Cost of Capital and why companies evaluate
.their cost of capital then what is meant by CAPM

:The Cost of Capital

Crundwell, F. (2008) mentioned that, companies need to attract

both investors to purchase shares in the company and lenders to
loan money to the company in order to provide the required flow of
cash for the company to support its operations, plans and
strategies. In order to attract investors and lenders to provide the
required flow of cash, companies need to give them something in
return as a reward. This reward is usually a cost to the company and
is known as the Cost of Capital, Crundwell, F. (2008). This Cost of
Capital reflects two different costs of rewarding. The first one is the
cost of rewarding the owners, which known as the Cost of Equity.
This reward could be either in the form of dividends or by the
increase of their share prices in the market. The second one is the
cost of rewarding to the lenders, which is known as the Cost of Dept
and this is usually in the form of interest rate. The combination of
those two costs is the weighted average Cost of Capital, as
described by Crundwell, F. (2008). In addition, Cockburn I. and
Lerner, J (2006) described the Cost of Capital as a critical
benchmark for assessing commercial viability of a project or
investment by Measuring the opportunity cost of resources
employed, often used as a “hurdle rate of return” to decide whether
to invest in a company and it is used as a “discount rate” to

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Raid Mutter Bangor University
MBA Banking & Finance International Financial Markets

evaluate future cash flows. This brings us to the understanding of

how important it is to evaluate companies Cost of Capital in order to
increase their return to avoid shareholders selling their shares,
which will negatively affect the company's share price and the
increase in the cost of dept to the lenders due to the higher risk
.they are taking

:(Capital Asset Pricing Module (CAPM

Jagannathan & McGrattan (1995) discussed that, the CAPM was

developed, at least in part, to explain the differences in risk
premium across assets. According to the CAPM, these differences
are due to differences in the riskiness of the returns on the assets.
The model asserts that the correct measure of riskiness is its
measure—known as beta—and that the risk premium per unit of
riskiness is the same across all assets. Given the risk-free rate and
the beta4 of an asset, the CAPM predicts the expected risk premium
.for that asset in the market
Cuthbertson, K. and Nitzsche, D. (2008) stated that CAPM "provides
an equation for determining the return on a stock". They also,
:described that it is expressed as
(ER = r + β (ERm – r
Which means that the return on any stock can be viewed as being
equal to the risk free rate (r) which is added to risk premium β (ERm
.(– r) as stated by Cuthbertson, K. and Nitzsche, D. (2008

:The relevance of CAPM to the Cost of Capital

Jagannathan & McGrattan (1995) describe the relevance between

CAPM and the Cost of capital. This is basically that in real life,

Investopedia (2009) the online dictionary described Beta by 4

stating that " Beta is calculated using regression analysis, and you can think of
beta as the tendency of a security's returns to respond to swings in the market. A
beta of 1 indicates that the security's price will move with the market. A beta of
."less than 1 means that the security will be less volatile than the market

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Raid Mutter Bangor University
MBA Banking & Finance International Financial Markets

corporate managers do not understand what shareholders want.

Owners send general messages to managers through the stock
market by basically selling their shares when they do not like what
managers doing, which leads to drop in share price in the market.
Then, Jagannathan & McGrattan (1995) goes on and argue that
capital budgeting has a central role in both the theory and practice
of managerial finance. The theory suggests a simple rule that
mangers should follow when making capital expenditure decisions.
This rule is to maximize the value of the firm, which lead to a classic
theoretical recommendation that managers only invest in those
projects with positive net present value. But in practice this simple
rule is not a simple process to adopt. Jagannathan & McGrattan
(1995) suggest that a key input to that process is the cost of capital,
which depends on the risk associated with the investment, describes
the expected rate of return that the investors will require in order to
invest. Therefore, managers need to understand how investors
assess that risk associated with the investment and how they
determine what risk premium to demand for that investment where
CAPM plays that role. McNulty, J. et al (2002) described CAPM as the
standard formula for estimating the cost of equity capital. Also, in
the CAPM, the cost of capital is an exact linear function of the rate
on a risk-free project and the beta of the project being evaluated.
Therefore, a manager who has an estimate of the beta of a potential
project can use the CAPM to estimate the cost of capital for their
.(project, Jagannathan & McGrattan (1995

Finally, although CAPM has been criticized for its inaccuracy in the
description of the expected returns and alternatives models have
been found, such as the three factors pricing model by Fama and
French as highlighted by Fama, E. and French, K. (1997), Da, Z. et al
(2009) argue that CAPM is satisfactory by stating that "Overall, there is little
evidence in the data to change one’s prior beliefs that project cost of capital
."estimates provided by the CAPM are satisfactory

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Raid Mutter Bangor University
MBA Banking & Finance International Financial Markets

:Conclusion

Companies need to raise their capitals in order to support its projects. There are
several ways for raising that amount of cash. Raising it from the equity market as
issuing shares, and from the bond market as issuing bonds are the most common ways
to do so and there are processes to be followed when using these methods to raise the
.capital of a company

Companies need to evaluate their Cost of Capital in order to improve their

performance and increase their return to avoid shareholders selling
their shares, which will negatively affect the company's share price
and the increase in the cost of dept to the lenders due to the higher
risk they are taking. Therefore, companies use CAPM as the standard
.formula for estimating the cost of equity capital for their evaluation

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Raid Mutter Bangor University
MBA Banking & Finance International Financial Markets

:References

A Practical Guide on Listing: World Class Service for World.1

Class Companies (2002). London. London Stock Exchange plc.
Available from:
http://www.londonstockexchange.com/companies-and-
advisors/listing/float/practical-guide-to-listing.pdf (accessed on
(9 November 2009
Cockburn, I and Lerner, J. (2006) The cost of Capital for Early-.2
Stage Biotechnology Ventures (online). Available from:
http://www.analysisgroup.com/uploadedFiles/News_and_Event
s/News/Cockburn_Lerner_CoC_in_%20Biotech.pdf (accessed
(11 November 2009
Conte , C. & Carr, A. (2008) An Outline of the U.S. Economy . Available.3
from: http://usa.usembassy.de/etexts/oecon/index.htm (Accessed 12
(November 2009
Crundwell, F. (2008) Finance for Engineers: Evaluation and.4
.Funding of Capital Projects. London. Springers
Da, Z., Guo, R. & Jagannathan, R. (2008) CAPM for Estimating.5
the Cost of Equity Capital: Interpreting the Empirical Evidence
(Online). Available From:
http://www.accc.gov.au/content/item.phtml?
itemId=836242&nodeId=e889d5bbab943891a8c41b4e3ff5f4d
4&fn=Ravi%20-%20paper.pdf (Accessed on 13 November
(2009
Fama, E. and French, K. (1997) Industry costs of equity..6
Journal of Financial Economic (online). Available from:
http://www.sciencedirect.com/science?
_ob=ArticleURL&_udi=B6VBX-3SWV8XR-
2&_user=10&_coverDate=02%2F28%2F1997&_rdoc=1&_fmt
=high&_orig=browse&_sort=d&view=c&_acct=C000050221&

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Raid Mutter Bangor University
MBA Banking & Finance International Financial Markets

_version=1&_urlVersion=0&_userid=10&md5=2764cae1bf0c1
(8479aa061ea7a4d04c9 (accessed 15 November 2009
Investopedia (2009) Beta (online). Available from:.7
http://www.investopedia.com/terms/b/beta.asp (Accessed 12
(November 2009
Jagannathan, R. & Ellen R. McGrattan, E. (1995) The CAPM.8
Debate. Federal Reserve Bank of Minneapolis Quarterly
Review. Vol. 19, No. 4, pp. 2–17. Avaiable from:
http://www.minneapolisfed.org/research/QR/QR1941.pdf
((accessed 6th of November 2009
McNulty, J., Yeh, T., Schulze, W. & Lubatkin, M. (2002) What is.9
Your Real Cost of Capital? Harvard Business School Publishing
Corporation (Online). Available from:
http://www.cosinconsulting.com.br/site/artigos/What_is_your_r
.(eal_cost_of_capital.pdf (accessed 12 November 2009
Peters, M., Timmerhaus, K. & West, R. (2003) Plant design and.10
economics for chemical engineers. 5th Edition. New York,
McGraw-Hill Professional
Yalden, R., SARA, J., Paton, P., Gellin, M., Davis, R. & Condon,.11
M. (2008) Business organizations: principles, policies and
practice (Online). Toronto. Emond Montgomery Publication.
Available From: http://books.google.com.sa/books?
id=SgoL3TVJGPUC&printsec=frontcover#v=onepage&q=&f=f
(alse (accessed 15 November 2009

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