Documente Academic
Documente Profesional
Documente Cultură
Ashlesh Mangrulkar
B18014 (Section A)
22-OCTOBER-2018
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
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
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.
Where
To calculate CAPM we need historical data, which has been compiled by L.E.K. and given
below:
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.
STEP 3
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.