DUBLIN INSTITUTE OF TECHNOLOGY

International Capital
Markets
Raza G. Mujtaba, Joseph Kinvi, Shauna Porter

Abstract: The purpose of this project includes some diverse areas of finance; it involves
conducting a literature review of the different concepts of finance particularly the CAPM
and WACC. Secondly this essay involves a research about a FTSE 100 company, which in
the case of this essay is BP Plc. The research includes the calculation of the Beta-
coefficient for the company. In the calculation of the CAPM and subsequently the WACC,
the 3 month UK Treasury Gilts was used as risk free rate of return. In the final part of the
essay the three inputs calculated were used to reach an expected return for the company.
Three different but plausible scenarios were used to reach the expected returns in the light
of different economic and financial commentary available in both the literature and the
Media Information. Ultimately, an evaluation on the strengths and weaknesses of the two
models was conducted.
Table of Contents
Page

Literature Review:

Capital Asset Pricing Model 3

Weighted Average Cost of Capital 4

Risk Free Rate 7

Beta 7

Expected Market Return 10

Report 12

Strengths and weaknesses 13

Appendixes 14

References 18

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Capital Asset Pricing Model

Capital asset pricing model (CAPM) is one of the most important developments in modern
capital theory. CAPM was developed by William Sharpe (1964), John Lintner (1965) and Jan
Mossin (1965). The capital asset pricing model states that the expected return on an asset
above the risk-free rate is linearly related to the non-diversifiable risk which is measured by
the asset’s beta. The CAPM was developed to explain the variances in the risk premium
across assets. According to the CAPM model these differences are due to the differences in
the riskiness of the returns on the assets. CAPM states that the riskiness of an asset is
measured by its beta and that the risk premium per unit of riskiness is identical across all
assets. Therefore if the risk-free rate and the beta of an asset are known the CAPM model
predicts the expected return for the asset. The CAPM is widely used by managers
undertaking projects; the reason for this is that the CAPM allows a firm to calculate the return
that its investors demand. (Michailidis et al 2006 p.79).

However like any other financial theory the Capital asset pricing model is based on a number
of assumptions and these are as follows:

 Investors are risk averse;

 Investors only care about mean and variance;

 The investors focus on short-term;

 Capital markets are perfect i.e. investors can’t affect prices, there are no transaction
costs and capital is borrowed at risk-free rate. (Levy 2010, p.45).

The main advantages of the CAPM model are that firstly it allows firms to estimate the risk
of the cash flows of a potential investment; secondly firms can use the model to estimate the
cost of capital of project and the rate of return that must be paid to investors if they are to
invest in the project. However despite all these advantages the CAPM model is under severe
and ongoing empirical and theoretical attacks. Many of these attacks are based on empirical
studies which reveal that the CAPM does not go hand in hand with empirical asset pricing.

Studies that Support the CAPM model

In 1972 an empirical study was carried out by Jensen, Scholes and Black the results of which
supported the capital asset pricing model. The study was carried out using monthly return

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data and portfolios rather than individual stocks. Using these Jensen et al tested whether the
expected returns were linear with the beta. The reason they used portfolios rather than
individual stock was that by combining securities into a portfolio the business risk can be
diversified thereby leaving financial risk which enhances the accuracy of the beta estimates
and the expected return of the portfolio securities. Jensen et al found that the data agreed with
the predictions of the CAPM i.e. that the relationship between the expected return and beta
was linear and that portfolios with high betas had high expected returns and portfolios with
low betas had low expected returns. Another empirical study that supports the CAPM model
is of Fama and McBeth (1973). Fama and McBeth examined whether there is a positive linear
relationship between expected returns and the beta. The results they obtained from the study
support the CAPM model. (Fama and French 2004).

Studies that challenge the CAPM model

In the early 1980s several studies suggested that the variations in the expected returns were
explained by variables other than the beta of an asset. In 1981 Banz challenged the CAPM by
demonstrating that the size of the firm explains the differences between the expected returns
of securities. Banz concluded that the average expected return on securities of small firms
were greater than the expected returns on securities of large firms. (Fama and French 2004

In conclusion many studies have been developed over the last number of years some of which
support the CAPM model, while others challenge the theory.

The Weighted Average Cost of Capital (WACC)

In the most general terms the cost of capital is used as a weighted average of the cost of
different sources of capital. Since Ezra Solomon first formally developed the idea of the
Weighted Average of cost of capital (WACC), there have been very helpful developments in
the WACC with the developments in the capital structure theories particularly by Modigliani
and Miller. Nevertheless even today there are some question marks regarding the use of the
WACC and its assumptions. In this essay the assumptions involved and the reservations of
some economists about the WACC will be discussed.

The General Formula for WACC

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Where

S is the market value of the common stock/equity at instance of calculation.

D is the Market value of the debt at instance of calculation

i is the yield on debt or the interest rate

r is the rate of return on the common stock/equity.

There is an alternative to using the market values of the common stock and that is the book
values for the firm. However, this alternative weighting scheme is usually rejected in favor of
weights determined by market values, because, as the argument goes, the former reflects a
past capital structure rather than the present one. (Arditti, F, 1973).

WACC and Taxes:

Modigliani–Miller theorem states that the value of two firms with different capital structures
is same if the assumption of “no taxes” in the system is held (Heins, J and Sprenkle, C, 1969).
Another assumption in the WACC is that there is a constant flow of funds or cash flows for a
forcible period. Keeping both of the assumptions in mind the WACC is no different than the
average cost of capital for any positive net-present-value (NPV) project (Arditti, F, 1973).
However, there have been questions raised by some academics and finance professionals
about the above two assumptions which will be discussed in the later part of the essay. Also
one more general belief in the finance industry and which is usually referred to when
deciding on different sources of capital is that the debt is relatively less costly than equity,
however its use in the WACC is being questioned, this will be discussed in the following
part.

Some Reservations

Reilly and Wecker (1973) show that the conditions under which Solomon first formally
developed the weighted average approach to the cost of capital are rather restrictive. Linke
and Kim (1974) and Ezzell and Porter (1974) argue that these restrictions as to cash-flow
patterns are not necessary and that a weighting approach to computing the cost of capital is
valid as long as the firm's leverage position is maintained. The phenomenon that debt is a
more preferable source of raising financing because of its tax advantage is widely agreed but

5
its use to lower the cost of debt in the WACC has been questioned. Arditti and Levy (1977)
state;

“We do not deny that debt carries an income generating advantage over equity due to
the tax deductibility of interest. However, we disagree with the practice of lowering
the cost of debt component in the weighted average cost of capital formula by these
tax savings …because these savings have already been accounted for in the cost of
equity calculation. Consequently, to also reduce the cost of debt by such savings is to
count them double in constructing the cost of capital figure.”

Arditti and Levy (1977) provide a comprehensive example to explain the above point which
is available in the Appendix (Example 1) of this essay. As to the assumption of the cash flow
is concerned the literature contains no generally accepted specification of the firm’s cash
flows. However, Nantell and Clarson (1975) argue that there are two cash flow concepts that
dominate the literature. One is the after tax net operating income, while the “alternate”
concept identifies the cash flows in terms of the ultimate flow of funds to the investors in the
firm, debt, and equity holders. Each of these concepts implies its own specification of the
definition of the firm’s cost of capital and if Ko is attributed as cost of capital for the first
assumption and Ko* for the second one respectively the cost of capital will depend on the
above relationships which are stated below;

X = expected net operating income t = firm's marginal tax rate

V = market value of the firm ko = firm's overall cost of capital.

The specification resulting from the alternate cash flow concept is

F = k,B, expected interest payments to the bondholders

k, = investor's expected return on debt B = market value of the firm's debt

k*o ^firm's overall cost of capital

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(X - F)(l - t) = expected earnings available to equity holders.

From the above analysis it could be said that the cost of capital will be different for the above
approaches/assumptions i.e. Ko≠Ko*.

Hence the whole idea of deciding on the firm’s cost of capital depends on how and which
assumptions are used by the managers. However it must be noted that not all the generally
accepted assumptions are relevant, for example the tax efficiency of the cost of debt, and can
manipulate the cost of capital figure for the firm and lead to misjudgments.

The Risk Free Rate

The risk free rate is the lowest rate of return a company will offer. It is a rate that an investor
would expect to receive from a risk free investment. The higher the risk, the higher the return
expected. A treasury bill is considered a risk free investment because it will return the same
rate regardless of the state of the economy, where as an internet Start-up Company will
fluctuate with the economy meaning the return is riskier and an investor will want a higher
return.

In analysing the CAPM model the risk free rate used is the annualised yield on three-month
UK treasury bills according to Financial Times (FT.com, 2011). The annualised compounded
risk free rate is 2.54%1 However in the analysis; the data sourced is on a weekly basis. The
weekly annualised compounded risk free rate is 0.0484% 2. However, even though the
treasuries are concerned to be risk free and do not therefore offer much higher yield, there is a
possibility that in near future the yield may go up because from macroeconomics it is
understood that when the inflation is feared in the economy the yields on the treasuries tend
to rise as investors want to cushion themselves from any inflationary write-off in the value.
Also, at the same the fiscal situation needs to be taken in account when estimating a risk free
return because as in the case of Ireland Portugal and Spain have found themselves impossible
to raise the funds in the bond market. Therefore, the National Debt level of the economy also
need to looked at and may cause the risk free rate to rise in the future.

1
(100[1+0.0063]^4)
2
([1+.0254]^(1/52)-1].
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Beta
Beta is calculated using the slope of the regression line, which measures the relative volatility
of BP compared to the market. It is essentially a measure of risk. Analysts generally use
monthly returns over a five year period to establish the regression line and estimate the beta
coefficient.

To verify the beta estimation made by the analysts our group gathered weekly returns from
1/1/2007 until 8/3/2011 from Yahoo! Finance and Data Stream (see table 6 in appendix). The
basic regression line obtained a slope of 0.96 with the data gathered from Yahoo! Finance.
The basic regression line was calculated using the market returns and the risk premium, both
methods obtained the same result.

The basic regression line calculated using data from DataStream resulted in a slope of 0.95.

In calculating CAPM for our analysis the beta used will be the beta calculated from Yahoo!
Finance as it has a higher R squared. This means that the information is a better fit and
therefore a more accurate measure of risk.

The timeline chosen is from 2007 because the crisis predominately started in mid-2007 and
got worse in 2008. The economy started to recover in 2009 and remained steady in 2010.
However 2010 was not a good year for BP. Weekly data was chosen because BP’s share
price was very volatile in mid 2010. This massive drop can be seen graph 1 in the appendix.
The sudden and massive drop in BP’s share price was due to an oil spill in the Gulf Stream,
Mexico that started in April and carried on until it was officially stopped in September. There
was an explosion that killed 11 people and let millions of gallons of oil spill out into the Gulf.
This had a devastating effect on the marine life, the coastline, the fishing and the tourism
industry. The firm had a constant negative presence in the media which caused large
amounts of speculation about the stock and an increase in volatility of the share price.
However, the share price started its correction in the market in late 2010 and early 2011 as
seen in the graph.

Estimated and the Financial Analyst Beta

The Beta calculated in this essay is slightly different than the one found on the financial
website such as the FT.com and Reuters. However a close inspection reveals that the Beta in
FT.com is quoted from Reuters and is not analysed separately at FT.com. The possible reason

8
for the difference may involve that the analyst could be using different markets i.e. all the
markets where the stock might be quoted but for the purpose of this essay only the FTSE 100
was selected. Nevertheless, the difference in the two Betas is around 0.143.

Beta with and without the Risk Premium

The Beta was also calculated with the Risk Premium to see the impact of the risk free return
on the measure of the Beta. However the difference is almost negligible mainly due to the
low interest rates set by the Bank of England to help boost the aggregate demand in the
economy and prevent a double dip recession. See Appendix Figure 1 and Figure 2.

Expected market return

This represents the predicted return on the FTSE 100 in a following year based on market
expectations (from analysts), historical data and media information.

Historical data
The table represents the return on the market (from 1985 to 2010) 4. The table is very volatile
and recently, it shows a considerable decline in return from 2006 up to 2008. The market
returns recovered in 2009 and stabilised in 2010.

An analysis of the first ten week returns of 2011 could help in having a fair judgement about
what the return on the market could possibly be in 2011.

The first ten weeks of 2011 generated a return of (-4.44%)5 which shows signs of
underperformance of the market and if this trend continues. This compares a gain of 1.38% 6
in the first 10 weeks of 2010; with the market ending up with a gain of 9% at the end of the
year.

The start of the year has proven to be a very turbulent period for the market. The FTSE 100
has been in decline for the first ten weeks. (See graph). This could be a good proxy to

3
1.10-.9604* Please refer to the Appendix Fig 1 and 2
4
See table 3 in appendix
5
See table 4 in appendix
6
See table 4 in appendix

9
determine what could be the expected return on the market in future weeks to come.

10 weeks return 2011

6200
5800
5400
11

11

11

11

11

11

11

11
11

11

11
0

0
0

0
/2

/2

/2

/2

/2

/2

/2

/2

/2

/2

/2
1

3
/0

/0

/0

/0

/0

/0

/0

/0

/0

/0

/0
04

10

17

24

07

14

21

28
31

07

14
Chart 1.0

Historical events are more or less reflected in the historical return shown in fig 1. The
financial crisis started in 2007 leading to the collapse of the financial market in 2008. This is
reflected in the percentage return during these 2 years. Many financial institutions collapsed
during the recession. In the 2009, the market bounced back after the intervention of
governments globally to prevent worldwide financial meltdown. These bailouts have
contributed to the recovery of markets. Although in the year 2010, the financial markets
showed positive signs of the recovery. In terms of BP, the return of BP is almost identical to
the return mainly because BP is an energy company and the energy companies have a big
impact on the return obtained on the market. However, in 2010 the oil spill in the Gulf of
Mexico has seen BP share prices hit a record low and this effectively increased the firm’s
Beta coefficient as BP became a slightly riskier company in contract with all the other energy
firms on the market.

Media information
The start of 2011 has proven to be a turbulent period so far for the FTSE 100. The middle-
east is currently experiencing a high level of political instability leading to a sharp increase in
oil price due to a shortage of oil supply. Energy firms have a big impact on the FTSE 100
return and since there is a shortage in oil supply, this will effectively be reflected in the return
on the FTSE 100. Firms like HSBC and Lloyd’s group had started making profit again in
2010 and this is expected to continue throughout the year 2011. This could boost the
performance of the FTSE 100 during the year 2010.

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Market expectations from analysts
The ECB has announced a possible interest rate hike in the next coming months (ref). This
will increase the Risk-Free rate return but will slow down any possible extravagant growth.
The OECD predicts a slow down in the UK’s economy during the year but Mike Lenhoff,
chief strategist of Brewin Dolphins insists that the UK’s economy has a minimal impact on
the FTSE 100 because “70% to 75% of income is generated comes from abroad”. It is
predicted a rather modest, yet optimistic expected return of 7%. A more pessimistic
prediction is that of Kevin Goldstein-Jackson of Financial Times. Kevin Goldstein-Jackson
predicts a negative expected return of (-19%) because he believes that bankers in the UK will
use their bonuses “to invest in gold and other commodities and let the market plummet.
Based on all this information collected, the expected return could be predicted according to
certain probabilities.

Report on Expected market returns

Recession: One far reaching side of the returns is expected where the economy is expected to
find itself in recession again i.e. a double dip recession. For the purpose of this essay a
probability of 0.3, 0.2 and 0.5 is allocated to that outcome. The judgement, albeit subjective,
is based on the possibility of the UK economy taking a hit of the austerity measures
introduced in the 2010/2011 budget by the coalition government. The most plausible
probability for that matter has to be 0.3 particularly because of the ECB announcing a
possible (read: almost certain) rate hike in April 2011 which can put pressure on the Bank of
England (BoE) to follow the suit in order to keep the funds in the UK and prevent investors
fleeing the City for other European Capitals. Another, assumption that makes the possibility
of a recession even more plausible i.e. 0.4 is the recent comments by the BoE chief economist
Spencer Dale, which indicated that the forecasts for the growth by the Chancellor of the
Exchequer are too optimistic. Mr. Dale stated

“The risks from continuing global price pressures and the effects of the prolonged
period of above-target inflation meant that the level of demand consistent with
achieving the inflation target had probably fallen,” Mr Dale said.

Stability: The probabilities assigned to stability are 0.6, 0.75 and 0.5 which suggests that the
possibility of the stable growth will range from 0.5 to 0.75 this judgment is based in the
following. At the end of the year 2010, analysts were predicting an average market return of
11% for the year 2011 according to a poll of strategists and market analysts published in late

11
2010, which included analysts from Morgan Stanley BNP Paribas and Goldman Sachs.
However this was before the crisis in the Middle East and the diaster in Japan which will
certainly have an impact on the UK assets of the Japanese firms mainly in the banking
industry. Paul Kavanagh, partner at Killik & Co. predicted that there will be a “strong
dividend growth during the year and interest rates will be pinned to the floor”. If this remains
the case the probabilities above may well be justified.

Boom: The possibility of such an outcome is almost Nill, however a probability of 0.05-0.1
have been assigned to this. See Appendix Table 5 for the calculation of the E(R).

Strengths and Weaknesses of CAPM and WACC

Strengths
1. CAPM is easy to calculate and understand.

2. It includes market returns which makes the cost of equity calculated more realistic.
This is not the case when the cost of equity is calculated using the Gordon growth
model.

3. The weighted average cost of capital is an important concept as it allows companies to

estimate the minimum rate of return they must pay to investors to secure finance.

4. The weighted average cost of capital can be used as a discount rate by companies to
analyse investment opportunities and ensure that they invest in projects that will
create value for the firm.

Weaknesses
One of the weaknesses of the CAPM is that it is based on a number of assumptions. These
include the following:

1. Capital markets are perfect i.e. there are no transaction costs, there are no taxes, and
that all investors are risk averse;
2. Investors are not diversified;
3. Individuals can borrow at the same rate as companies.

Key findings

The given cash flow stream was examined using three expected returns and it was found that
if there was no possibility of boom in the future and when the recession’s probability was

12
increased, the cost of capital i.e. the WACC rises which is a fair finding. This can be
examined in table 7 in the appendix.

Appendix

Table 1

Beta using Market Return

0.2
0.15
0.1 %BP
0.05
0 Linear (%BP)
-0.05 0 f(x) = 0 x50− 0 100 150 200 250
-0.1 R² = 0
-0.15
-0.2
-0.25

Table 2

Beta using Risk Premium

0.2
0.1 %BP
0 Linear (%BP)
f(x) = 0 x − 0
-0.1 0 R² = 0 50 100 150 200 250
-0.2
-0.3

Table 3

(Fig. 1 www.forecast-chart.com, 2011)

FTSE 100: Annual Returns

Year Percent Year Percent Year Percent Year Percent

1985 -10.5 1992 8.7 1999 6.2 2006 9.7

1986 28.3 1993 24.4 2000 -6.5 2007 2.1
1987 0.1 1994 -11.1 2001 -14.7 2008 -30.9
1988 4.3 1995 21.5 2002 -23.4 2009 22.1
1989 25.8 1996 13.1 2003 12.4 2010 9.0
1990 -12.5 1997 25.4 2004 8.7
1991 23.7 1998 16.4 2005 18.1

13
 The annual gain or loss in the FTSE 100 index from 1985 to present.
Dividends are not included.

weekly
retrurn
weekly 2010
2011 FTSE 100 return 2010 2010 FTSE 100 Table 4
 
04/01/2011 5984.3   04/01/2010 5534.2 10 weeks
- comparison of
1.424% 2010 and 2011
10/01/2011 6002.1 0.297% 11/01/2010 5455.4
- (from Yahoo!
2.794% Finance)
17/01/2011 5896.3 -1.763% 18/01/2010 5303
-
2.159%
24/01/2011 5881.4 -0.253% 25/01/2010 5188.5
-
2.459%
31/01/2011 5997.4 1.972% 01/02/2010 5060.9
1.612%
07/02/2011 6062.9 1.092% 08/02/2010 5142.5
4.194%
14/02/2011 6083 0.332% 15/02/2010 5358.2
-
0.069%
21/02/2011 6001.2 -1.345% 22/02/2010 5354.5
4.581%
28/02/2011 5990.4 -0.180% 01/03/2010 5599.8
0.461%
07/03/2011 5828.7 -2.699% 08/03/2010 5625.6
-
0.563%
14/03/2011 5718.1 -1.898% 15/03/2010 5593.9
10 weeks 10 weeks 1.380%
return 2011   -4.444% average  

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Table 5: Expected Market Returns:

Possibility Probablity Estimated Return E(R)

Recession 0.3 5.43% 1.63%
Stability 0.6 7.43% 4.46%
Boom 0.1 9.93% 0.99%

Expected Return 7.08%

Possibility Probablity Estimated Return E(R)

Recession 0.2 5.43% 1.09%
Stability 0.75 7.43% 5.57%
Boom 0.05 9.93% 0.50%

Expected Return 7.15%

Possibility Probablity Estimated Return E(R)

Recession 0.5 5.43% 2.71%
Stability 0.5 7.43% 3.71%
Boom 0 9.93% 0.00%

Expected Return 6.43%

Table 6: beta estimates

Analyst: Beta estimate for BP:

Financial Times 1.10
Reuters 1.10
Yahoo! Finance n/a
DataStream 1.035
Beta calculated 0.96

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Table 7 Cash Flows

Scenario 1
Weights Cost of Capital Tax Adjustment
Debt 32% 3.10% 72% 0.721%
Equity 68% 7.08% 4.790%
5.511%

NPV
-1000000 379106.5 404217.3299 468237.6294
251561.4

Scenario 2
Weights Tax
Debt 32% 3.10% 72% 0.721%
Equity 68% 7.15% 4.841%
5.562%

NPV
-1000000 378924.1 403828.6167 467562.3748
250315.1

Scenario 3
Weights Tax
Debt 32% 3.10% 72% 0.721%
Equity 68% 6.43% 4.350%
5.071%

NPV
-1000000 380694 407609.8156 474144.6661
262448.5

Example 1:

Assume that interest is not tax deductible, and that X = 100, iD = 10 and t = 5. What is the
maximum annual total dividend payment that shareholders may expect? Since iD is assumed
to be non-deductible, the answer is found by computing (1- t)X - iD, which is 40. Now take a
turn towards reality and allow it to be deductible. Then the maximum expected dividend is
found by computing X - t(X - iD) - iD which is 45. Since this is precisely how the market

16
would compute the firm's expected dividend stream, we see that the presence of interest tax
deductibility raises the expected dividend payment.

Since the post-tax cost of equity, symbolized by r, (and equal to r(l - t) in the perpetuity case),

is defined by = where dj is the expected dividend

payment in year j , we see that by raising dj, interest tax deductibility affects rt. (Recall that
the S value is given, and we are wholly concerned with the technical problem of calculating
the correct relationship between post-tax and pre-tax cost of funds figures.) The above
indicates that the tax advantages of debt have been accounted for in the cost of equity capital.

Graph 1

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References
Ezzell John R. and Porter R. Burr. "The Weighted Average Cost of Capital: Some Questions

On Its Definition, Interpretation and Use: A Comment" Presented at the 1974 Annual
Meeting of the Midwest Finance Association.

Fama, F E, French R K (2004) The Capital Asset Pricing Model: Theory and Evidence. 18(3)
p. 30-2. Available from Business Source Premier [Accessed 12 March 2011].

Heins A. James and Sprenkle Case M "A Comment on the Modigliani-Miller Cost of Capital
Thesis “American Economic Review.” 59 (1969): 590-592

Levy, H (2010) The CAPM is Alive and Well. 16(1) p.45-6 Available from Business Source
Premier [Accessed 11 March 2011].

Korosec, Kirsten. “BP Gulf Oil Spill: The Worst Case Scenario Looms for Company and the
Region” www.bnet.com (1 June 2010)

Linke Charles M. and Kim Moon K.. "More on the Weighted Average Cost of Capital: A
Comment and Analysis " Journal of Financial and Quantitative Analysis (December, 1974)

Michailidis, G et al (2006) Testing the Capital Asset Pricing Model: The Case of the
Emerging Greek Securities Market. Issue 4(2006) p. 79-80. Available from Business Source
Premier [Accessed 12 March 2011].

Nantell, Timothy J. And Carlson, C. Robert “The Cost of Capital as A Weighted Average”
Journal of Finance Vol.XXX No.5 (December 1975)

Raymond R. Reilly and William E. Wecker. "On the Weighted Average Cost of Capital"

Journal of Financial and Quantitative Analysis 8 (January, 1973): 123-126

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