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Name: Ashlesh Mangrulkar SID: B18014 SECTION A

Lex Service PLC – Cost of Capital


FM1 Assignment

Ashlesh Mangrulkar
B18014 (Section A)
22-OCTOBER-2018

Name : Ashlesh Mangrulkar SID : B18014 SECTION A


Name: Ashlesh Mangrulkar SID: B18014 SECTION A

Case Background

The conglomerate Lex Service has businesses in two areas : automotive distribution and
contract hire. It also owns substantial property.
Till 1983, it had operated in the electronics business as well. In 1991, it decided to focus
efforts on its core competence in automotive distribution and leasing in the UK. It
engaged in transactions that were necessary to strengthen the position of the firm, and
provide necessary resources for expansion. By May 1993, it had moved completely out
of the electronics business, netting £116.8 million. These funds had been useful in
acquiring new businesses in automotive distribution and leasing businesses. After its
termination with Volvo Car Corporation, it gained £100 million in concessions. It
immediately purchased Swan National Motor Group, Lucas Autocentres and the
Arlington Motor Group.
The firm is undertaking a thorough analysis on its cost of capital, to establish the worth
of its investment opportunities. For its capital budgeting process, it engaged the services
of L.E.K. Partnership, a consulting firm, to determine what rate of return it should expect
from these new investments it had made. L.E.K had suggested two appraoches:
1. Estimate cost of capital for Lex as a consolidated entity,
2. Develop individual cost of capital estimates for each division within Lex

Five Critical Financial Problems

1. Using Discounted Cash Flow Analysis


Lex Capital is employing Discounted Cash Flow Analysis to evaluate the worth of its
investments. In DCF, the expected present Value of cash flow is calculated, using an
appropriate hurdle rate.

CF: cash flow, k:discount rate, n: number of periods


Here we can observe two factors that affect Present Value calculations.
a.) Cash flow
b.) Discount Rate
The DCF model is sensitive to future cash flow projections. For each year, estimation of
the cash flow and expenditure becomes tedious and difficult. There is an uncertainty
that accompanies these calculations which increases with each additional year.

Name : Ashlesh Mangrulkar SID : B18014 SECTION A


Name: Ashlesh Mangrulkar SID: B18014 SECTION A

For calculation of discount rate, the Weighted Average Cost of Capital is calculated.
Calculation of multiple WACC for different divisions within a firm requires many data
points, as the risk profile varies for each division, and hence cost of equity and debt may
not be easy to calculate.
2. Computing Beta using Proxy firms
In the case, for finding the Weighted Average Cost of Capital for multiple divisions we
need to calculate the Beta for each. Since they are not listed, we need to find proxy
firms that are closest in comparison with each of the divisions, to find the value of Beta
(equity). It is tedious exercise to find public firms that only operate in one business and
have a size comparable to the private entity. The operating markets and geographies
have to be similar.
The average Beta of the industry is computed, it is then unlevered using average debt-
to-equity ratios, and then the Beta is re-levered using the private company’s
Debt/equity ratio.
The drawback of this method is that the size difference between the public and private
company is not considered. In most instances, publicly listed companies tend to be
larger than private companies.
3. Use of Capital Asset Pricing Model

For CAPM, there are a few assumptions that are to be considered before applying to any
financial problem. In case of Lex, its Beta was estimated to be 1.23, although its gearing
ratio had changed significantly recently, and hence its Beta was based on historic value
of leverage.
To use CAPM, extensive market data is required. For risk free rate of return, rf, we use
the yield on short term government bonds. Estimating Beta for a firm like Lex requires
extensive historical data, a regression analysis between market rate of return and daily
stock return needs to be carried out. The value of required rate of return can come out
to be negative if expected stock market returns is negative, hence we need to cancel out
market shocks.
The CAPM makes assumptions that investors can borrow and lend at risk free rate, but
in reality that is not the case.
4. Properties held by Lex
Currently, Lex owns properties that are undervalued when compared to its book value.
Its current market value is about 77% of book value. The current value of these
“investments” was around £31.4 million (book value) It acquired these properties as its

Name : Ashlesh Mangrulkar SID : B18014 SECTION A


Name: Ashlesh Mangrulkar SID: B18014 SECTION A

existing dealers moved to new locations. These were then reclassified as investment
opportunities. Lex Service’s management had set targets to dispose of these properties,
but market conditions were not favourable. The management needs to take a decision
to hold onto these properties and wait for market conditions to be favourable, or utilize
them for operational purposes.
5. Employing surplus funds in suitable Investments
Lex capital made investments worth £132.5 million in new acquisitions. It also used a
sizeable chunk of the freed up capital from asset sales to deleverage itself, paying off
£197 million in debt, which was well below management’s future target levels of 15%-
30%. From Lex Service’s historical precedent, it can be observed that they have
diversified into multiple businesses in the past, and hence the new investments that it
made. It sold of its investments in electronics to Arrow to focus on its core businesses.
After its alliance with Volvo was ended, it re-entered the auto import business by
acquiring a controlling stake in Hyundai Car. In contract hiring and vehicle businesses, it
owns a controlling stake in most of the firms it operates.
Estimating the cost of capital was but one aspect of investment analysis.

Analysis & Interpretations


Consolidated Company
For our analysis we will use the following approach:
1.) Calculate the Required Rate of Return on equity using given historic Beta value
using CAPM Model.
2.) Calculate the WACC using the given tax rate, cost of debt and the equity rate.
3.) Use D/V and E/V values from the given target value of firm as given in Exhibit 6
STEP 1
The required rate of return on an investment is given by the Capital Asset Pricing Model:

Where

Ra = expected return; Rf = Risk Free Rate ; Beta = measure of riskiness of security

Rm = expected return from market.

To calculate CAPM we need historical data, which has been compiled by L.E.K. and given
below:

Name : Ashlesh Mangrulkar SID : B18014 SECTION A


Name: Ashlesh Mangrulkar SID: B18014 SECTION A

1. Risk Free-Rate
Bonds Non-indexed bonds Inflation Indexed Bonds
Short Term Guilts 6.30% 3.4%
Medium term bonds 6.8 3.4
Long-term bonds 7.20% n.a.

Risk Free Rate

We are using non-indexed bonds for calculating Rf, as in Table B,


the average equity returns are non-indexed as well. Furthermore, in DCF we use nominal
discount rates.
2. Equity Risk Premium (Rm – Rf)
It is return above risk free rate of return that investors seek in a security. It is generally
caclulated by taking as long term data as possible, to cancel out any short term
fluctuations. For long term, we generally use arithemtic averages.

Guilts/Equities Average Nominal Returns


Short term gilts
1919-1993 5.47%
1946-1993 7.2
Medium to long term gilts
1919-1993 6.74
1946-1993 7.14
Equities
1919-1993 14.68
1946-1993 16.63
We use as long term data as possible for our calculations.
Market Returns (Rm) = 14.68% ; Risk Free Return (Rf) = 6.74%
Given Beta for the firm is 1.23. Since this is levered Beta w.r.t 35%-40% debt to total
capital. Using this Beta we’ll calculate unlevered(asset) Beta, then calculate new Beta
using target Debt/Capital Ratio.
Unlevered Beta =(E/V)*1.23 = {1/(1+D(1-T)/E)}*1.23 = 0.877318
Levered Beta = 0.877318*(D+E)/E (with target D/E ratio) = 1.035235
Thus the Expected Rate of Return for Lex Service is
R = 7.2% + 1.035325*(14.68-6.74) = 15.42%
STEP 2
Now we calculate the Weighted Average Cost of Capital (WACC)
The WACC is also referred to as the company’s cost of capital

Name : Ashlesh Mangrulkar SID : B18014 SECTION A


Name: Ashlesh Mangrulkar SID: B18014 SECTION A

Re = Cost of equity; Rd = Cost of debt; E =Market value of equity;


D =Market value of debt; V= E+D
On page 6 it is given Rd = 8.4% (pre-tax cost of debt), and marginal corporate tax rate =
33%. The value of debt to equity is:
Exhibit 6 Market-Value Target Range
Midpoint (Debt to Equity)
Consolidated Company
0.18
WACC = {8.4*(1-0.33)*0.18/1.18} + {15.42*1/1.18} = 13.92%
For consolidated company, the WACC is 13.92%
Discount Rate by Business
Lex Service operates in 3 lines of business
1.) Automotive Distribution
2.) Contract Hire
3.) Property
We will proceed with calculations for WACC in a similar fashion as done for consolidated
company. However, there is a caveat. We need to calculate the Beta values for each of
these divisions. Since they are not publicly listed firms, we have to use comparable firms.
The following steps will be employed:
1. Take average values of Beta(asset) for comparable companies
2. Find the value of equity beta using the equation
Beta(Asset) = (E/V)*Beta(equity)
3. Find Re from CAPM
4. Calculate value of WACC for each division
5. Calculate consolidated WACC for Lex Service using weighted means approach
from individual WACC.
STEP 1&2
Exhibit 8 Asset Beta Market Value Target(Debt/Equity) Beta(equity)
Automotive
Distribution 0.61 0.15 0.7015
Lex Vehicle Leasing 0.41 4.89 2.4149
Property 0.68 1.3 1.564
STEP 4

1. Automotive Distribution : 12.77%


2. Vehicle Leasing: 26.37%
3. Property : 19.62%

Name : Ashlesh Mangrulkar SID : B18014 SECTION A


Name: Ashlesh Mangrulkar SID: B18014 SECTION A

STEP 3

1. Automotive Distribution : 11.84%


2. Vehicle Leasing : 9.14%
3. Property : 11.71%
Now that we know the values of WACC for the individual businesses, we can calculate
the weighted Beta for the consolidated firm.
We can calculate new Beta based on weighted average asset values.
Debt Equity Total Beta(Equity)
Automotive Distribution 6.4 189.1 195.5 0.7015
Contract Hire 457.2 99 556.2 2.4149
Property 0 31.4 31.4 1.564
(millions of pounds)

Consolidated Company (Beta) 1.953033

Use this Beta in CAPM to get Re

Expected Return 22.70708291%

WACC for consolidated company

WACC = 0.85*0.22707 + 0.1525*(1-0.33)*0.084 = 20.10%

Name : Ashlesh Mangrulkar SID : B18014 SECTION A


Name: Ashlesh Mangrulkar SID: B18014 SECTION A

Recommendations

The management at Lex Service realises that it is a defining period and the investment decisions that
they take will affect the future source of returns in the long run. Since they are focussed on 2
operating areas, it is wise o move forward with the individual calculated cost of capital as a
benchmark. But it should not be the only parameter to asses the ‘worthiness’ of projects, as they are
accompanied by several ‘best-value’ estimates. As far as its investments in property is considered, it
should do a feasibility analysis of holding onto the property, as the firm is not in need of any instant
cash at the moment. It can look to reap profits when the property market is in boom.

Name : Ashlesh Mangrulkar SID : B18014 SECTION A