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Lex Service PLC: Cost of Capital Analysis

Lex Services PLC is concerned about estimating its cost of capital in 1993 as it is refocusing its business strategy and investing cash from selling businesses into new ventures. The cost of capital is required for capital budgeting to evaluate whether new projects will be profitable. Using the provided data and assumptions, the estimated cost of equity for Lex under its target capital structure is 14.55%. However, the weighted average cost of capital (WACC) of 13.189% should be used to discount total operating cash flows. Lex would benefit from some debt in its capital structure to lower its overall cost of capital. Multiple discount rates should be used to evaluate projects within Lex's different divisions given the varying levels of risk.

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714 views11 pages

Lex Service PLC: Cost of Capital Analysis

Lex Services PLC is concerned about estimating its cost of capital in 1993 as it is refocusing its business strategy and investing cash from selling businesses into new ventures. The cost of capital is required for capital budgeting to evaluate whether new projects will be profitable. Using the provided data and assumptions, the estimated cost of equity for Lex under its target capital structure is 14.55%. However, the weighted average cost of capital (WACC) of 13.189% should be used to discount total operating cash flows. Lex would benefit from some debt in its capital structure to lower its overall cost of capital. Multiple discount rates should be used to evaluate projects within Lex's different divisions given the varying levels of risk.

Uploaded by

Arup Dey
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd

Lex Service PLC

Q1. Why is Lex Services PLC concerned about its cost of


capital in 1993?

In 991, Lex implemented new business strategy that refocused


Its automotive distribution and leasing.

Lexs cash was Increasing as it sold its electronic business


and Volvo ended its agreement with Lex. To invest cash in
new businesses Lex required to estimate Cost of Capital.

Cost of Capital is required to do capital budgeting.


What role will an estimate of the cost of capital play within
Lex? In general, how can and do companies make use of
cost of capital estimates?

An investor invests money in the company if the


company is giving the desired rate of return

Required in evaluating whether new projects of


company are profitable or not. As it is a measure to
identify a project which satisfies ROI.

It will help in estimating present value of future cash


flows.
Q2. Using the data provided in the case, estimate Lexs
cost of equity under its future target capital structure
for the consolidated company.

A) Risk free rate used to obtain the estimate:

Risk free rate assumed = 7.2% since this is the rate for long term
U.K Govt. Bonds. (Table A)

Rm = 14.68 (Average Return on U.K Gilts Table B)

Levered Beta given = 1.23 (with current debt-total capital : 37.5%)

Unlevered Beta = 1.23 / {(1+(1-0.33)*(37.5/62.5)} = 0.877


Re-Levered Beta = 0.877 {1+(1-0.33)*(.18)} =
0.9827 (market target average debt to equity ratio is
0.18 exhibit 6

Cost of Equity, Re = Rf + B(Rm Rf) = 7.2 + 0.9827


(14.68 7.2) = 14.55%
B) Risk Premium used and estimation process:

Risk Premium is given by (Rm Rf) = (14.68 7.2) =


7.48%

We have used a market return of 14.68, since this is


the average total returns obtained in Equities in U.K
market over a long period of time.
C) Is your estimate of Lexs cost of equity appropriate as a
discount rate for Lexs total operating cash flows? Why or
why not?

No, cost of equity must be used to discount cash flows


to equity alone (cash avail to shareholders after all
expenses, reinvestment and debt repayment) and not
on total operating cash flows.

Weighted Average Cost of capital must be used


for discounting total cash flow:
WACC (Weighted average cost of capital)

WACC = (1 - T) * rd(D/V) + re * (E/V)

Rd = 8.4% (given) ; T = 33% ; re = 14.55% ; D/E=


0.18 ; D/V = .1525; E/V =0.8475

WACC = (1-.33)*8.4*(.1525) +(14.55 *(.8475)) =


13.189%
Q3. If Lex had no debt in its capital structure, what would be its
cost of capital? How could this estimate be used to value Lex?

If Lex had no debt, then cost of capital = cost of equity.

This cost of equity can be used to estimate the current value of


future cash flows to get the enterprise value(EV).

Subtracting obligations such as pension deficits from EV would


give us Lexs equity value.
If Lex operated with essentially no leverage in its capital
structure and then added a moderate amount of debt, how
would this affect its total value? How might we capture this
value impact of debt in our valuation analysis?
Incase of Lex it is beneficial for the company to have some amount of debt.

If company has no debt, B =0.877 (unlevered)

Re = 7.2 + 0.877 (14.68 7.2) = 13.759%

WACC = cost of equity = Re = 13.759%

Thus cost of capital increases from 13.189% to 13.759% if there is no debt.

Cost of capital decreases if debt is present because post-tax cost of debt is


lower than cost of equity and tax savings is associated with debt.
Q4. Should Lex use a corporate wise discount rate or multiple
discount rates to evaluate investment projects?

Multiple discount rate because:

Based on project th risk factor of each division is different

Multiple discount rate will give accurate judgment whether to proceed with the project.

Compara
Target Target ble Asset Leverage Cost of cost of
D/E E/V Beta Beta Equity debt WACC
Automoti
ve 0.15 0.87 0.61 0.67 12.22 8.4 11.36

Contract 4.89 0.17 0.41 1.75 20.31 8.4 8.12

Property 1.3 0.43 0.68 1.27 16.72 8.4 10.45

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