Case Background

Lex Service PLC is a company based out of United Kingdom. Currently, it has two major lines
of business: automotive distribution and contract hire (vehicle leasing and finance). Apart
for the two businesses, Lex is also in possession of substantial amount of commercial
property not required for operational purposes. Not long ago, the company had the sole
distributorship rights for Volvo in UK. Additionally, Lex had a presence in US in the form of
luxury hotels, vehicle parts distributors and electronic components distributors (mostly
through acquisition). The company acquired Schweber Electronics in 1981, which
contributed to 90% of Lex Electronics World wide’s revenue. Following the automobile
market slump in 1991, Lex decided to focus on its core competency i.e. automobile
distribution & leasing. Consequently, the electronics business was sold for £195.8 million in
a combination of cash and equity. In 1992, Volvo decided to terminate its contract
prematurely and as a result compensated Lex with £100 million. Although, the share price
fell 30% in response to the news, the funds received in the proceedings enabled Lex to
finance future growth initiatives.
Lex engaged LEK Partnership to estimate the company’s cost of capital. LEK decided to
employ capital asset pricing model (CAPM) in order to estimate the return on equity.
Additionally, it estimated the cost of debt for the company to be 8.4%. Using past data, LEK
also calculated the estimated β-values of the divisions as well as the consolidated company.
Using these data, the top management of Lex needs to calculate the company’s cost of
capital and evaluate future investment opportunities.

Kaustav Dey B18088

 Financial Problems

Calculating the cost of capital: - Lex is a conglomerate with three divisions, i.e., automobile
distribution, vehicle leasing & finance and commercial property. Naturally, these businesses
have varying degrees of risk as well as rates of return. All the three divisions have different
debt-to-equity ratios and β-values. However, it is important that we estimate the cost of
capital of the consolidated business along with the individual divisions. If the company is
planning to diversify into a different business segment altogether, the consolidated cost of
capital and β-value will serve as a benchmark. Similarly, if the company is evaluating the
acquisition of a business which falls under one of its business lines (distribution and contract),
the individual costs of capital and β-values needs to be considered.

Multiple estimates of capital costs: - In order to calculate the expected rate of return of
equity using capital asset pricing model (CAPM), LEK has considered multiple estimates for
the values of Rf (risk-free rate of return) and Rm (market rate of return). For risk free rate of
returns, LEK has considered the yields of short-term, medium to long term bonds and equity
risk premium for two periods i.e. 1919-93 and 1946-93. So, there are eight possible
combinations of Rm and Rf, which will give us eight different estimates of divisional and
consolidated cost of capital. Now the challenge is to determine which value of Rm is a more
accurate estimate of the current trends in the equity market. Similarly, we also need to
evaluate whether the selection of Rf shall depend on the expected timeline of returns (i.e.
short term, medium-term or long-term).

Improving EPS (Earnings Per Share): - Due to a slump in automobile sales in 1991 and the
consequent decision of Volvo to terminate the contract, the share price of Lex fell 30% in
response. In order to improve investor confidence, there is a dire need to improve earnings
per share. A closer look at the balance sheet reveals that the earnings per share excluding

Kaustav Dey B18088

extraordinary income is low and most of the revenue in 1991 and 1992 constitutes the
proceeds received from sale of businesses as well as compensation received from termination
of distributorship contract with Volvo. Thus there is a need to invest the sales and
compensation money received in profitable businesses in order to improve the EPS and
regain investor confidence.

Improving the gearing: - Part of the extraordinary income was used in repaying debt. So, the
debt-to-equity ratio has fell below the previous levels. In a bid to improve the EPS, Lex also
needs to increase the percentage of outsider’s funds in the company’s capital structure. The
current cost of debt is 8.40%. In order to take advantage of gearing, Lex needs to invest in
businesses with a rate of return significantly higher than 8.40%.

Property prices are below book value: - The substantial deal property in possession of Lex
Service PLC is non-operating in nature. The returns on these properties are in the form of
capital appreciation. However, due to some reason, there has been a negative growth in the
property values and consequently the current market prices are below book values. Thus we
need to evaluate the estimates of expected future rates of return. If the rates of return are
lower than that of the automobile distribution and contracting services, the properties could
be sold and the money can be invested in businesses with higher rates of return.

Kaustav Dey B18088

 Analysis & Interpretation

The first step is to calculate equity betas from the given asset betas. If we consider the debt-
beta to be zero (t=since, the return is virtually risk free), the equity beta values can be
obtained by: -
𝛽𝐸 = 𝛽𝐴 X (V/E), where 𝛽𝐸 =equity beta, 𝛽𝐴 =asset beta, V=capital, E=Equity

Division Asset Beta (E/V) value Equity Beta

Automotive 0.61 97.40% 0.63
Distribution
Contract Hire 0.41 22.60% 1.81
Property 0.68 100% 0.68
Consolidated 0.87 58.35% 1.23

Similarly, for target gearing, the equity beta values are as follows

Division Asset Beta (E/V) value Equity Beta

Automotive 0.61 86.96% 0.70
Distribution
Contract Hire 0.41 16.98% 2.41
Property 0.68 43.48% 1.56
Consolidated 1.04 84.75% 1.23

The cost of debt is estimated by LEK to be around 8.40%. The cost of equity can be
calculated using the capital asset pricing model (CAPM): -
Rs=Rf+β(Rm-Rf), where Rs=expected rate of return (equity cost of capital), Rf=risk free
rate of return and Rm=market rate of return.
However, there are eight possible combinations of Rm & Rf based on the historical data
provided.
Division: - Automotive Distribution Division: - Contract Hiring

Current Targeted Current Targeted

Rm(%) Rf(%) Rs(%) Rs(%) Rm(%) Rf(%) Rs(%) Rs(%)
14.68 5.47 11.24 11.93 14.68 5.47 22.18 27.71
14.68 7.20 11.88 12.45 14.68 7.20 20.77 25.26
14.68 6.74 11.71 12.31 14.68 6.74 21.14 25.91
14.68 7.14 11.86 12.43 14.68 7.14 20.82 25.35
16.63 5.47 12.46 13.30 16.63 5.47 25.72 32.42
16.63 7.20 13.11 13.82 16.63 7.20 24.31 29.97
16.63 6.74 12.93 13.68 16.63 6.74 24.68 30.62
16.63 7.14 13.08 13.80 16.63 7.14 24.36 30.06

Kaustav Dey B18088

Division: - Property Consolidated

Current Targeted Current Targeted

Rm(%) Rf(%) Rs(%) Rs(%) Rm(%) Rf(%) Rs(%) Rs(%)
14.68 5.47 11.73 19.87 14.68 5.47 16.80 16.80
14.68 7.20 12.29 18.90 14.68 7.20 16.40 16.40
14.68 6.74 12.14 19.16 14.68 6.74 16.51 16.51
14.68 7.14 12.27 18.93 14.68 7.14 16.41 16.41
16.63 5.47 13.06 22.92 16.63 5.47 19.20 19.20
16.63 7.20 13.61 21.95 16.63 7.20 18.80 18.80
16.63 6.74 13.47 22.21 16.63 6.74 18.90 18.90
16.63 7.14 13.59 21.98 16.63 7.14 18.81 18.81

The targeted value refers to the cost of equity obtained during the target gearing condition.
Now, we need to calculate the weighted average cost of capital (WACC).
WACC= (1-Tc) X Rd X(D/V) + Rs X (E/V), where Tc = effective corporate tax rate, Rd = cost of
debt, Rs = cost of equity, (D/V) = debt to capital ratio and (E/V) = equity to capital ratio.
Effective corporate tax rate = 18% Cost of debt = 8.4%

Current Targeted
Division (E/V) value (D/V) value (E/V) value (D/V) value
Automotive 97.40% 2.60% 86.96% 13.04%
Distribution
Contract Hire 22.60% 77.40% 16.98% 83.02%
Property 100% 0 43.48% 56.52%
Consolidated 70.84% 29.16% 84.75% 15.25%

To calculate the current (E/V) ratio and (D/V) ratio for Lex consolidated, we have adopted
the following approach (all the values are in million dollars)

Division Debt Equity (Book Equity Equity Capital

value) Market/Book (Market)
ratio
Automotive 6.4 189.1 1.26 238.27 244.67
Distribution
Contract Hire 228.6 49.5 1.35 308.61 537.21
Property 0 31.4 0.77 24.18 24.18
Total 235 270 571.06 806.06

Therefore, for consolidated company current (E/V) ratio= 70.84% and (D/V) ratio= 29.16%

Kaustav Dey B18088

Division- Automotive Distribution Division- Contract Hiring

Current Targeted Current Targeted

Rm(%) Rf(%) WACC(%) WACC(%) Rm(%) Rf(%) WACC(%) WACC(%)
14.68 5.47 11.12 11.93 14.68 5.47 10.34 10.42
14.68 7.20 11.75 11.72 14.68 7.20 10.02 10.01
14.68 6.74 11.59 11.60 14.68 6.74 10.11 10.12
14.68 7.14 11.73 11.71 14.68 7.14 10.04 10.02
16.63 5.47 12.31 12.46 16.63 5.47 11.14 11.22
16.63 7.20 12.94 12.91 16.63 7.20 10.82 10.81
16.63 6.74 12.77 12.79 16.63 6.74 10.91 10.92
16.63 7.14 12.92 12.89 16.63 7.14 10.84 10.82

Division- Property Consolidated

Current Targeted Current Targeted

Rm(%) Rf(%) WACC(%) WACC(%) Rm(%) Rf(%) WACC(%) WACC(%)
14.68 5.47 11.73 12.53 14.68 5.47 13.91 15.29
14.68 7.20 12.29 12.11 14.68 7.20 13.63 14.95
14.68 6.74 12.14 12.22 14.68 6.74 13.70 15.04
14.68 7.14 12.27 12.12 14.68 7.14 13.64 14.96
16.63 5.47 13.06 13.86 16.63 5.47 15.61 17.32
16.63 7.20 13.61 13.44 16.63 7.20 15.32 16.98
16.63 6.74 13.46 13.55 16.63 6.74 15.40 17.07
16.63 7.14 13.59 13.45 16.63 7.14 15.34 16.99

It is observed that the change in WACC with capital structure is negligible in case of contract
hiring and automotive distribution compared to property. The consolidated WACC of Lex,
however, changes significantly with change in capital structure (D-E ratio).
Interestingly, the consolidated WACC is higher than individual WACC.

Kaustav Dey B18088

 Recommendation

We observed that the value WACC varied significantly with different combinations of R m &
Rf. So, there cannot be a particular combination which is applicable to every situation. The
CAPM is a short term model and usually calls for short term interest rate. But this may not
be the right discount rate 10-15 years into the future. In our case there is a significant
difference between yield rates of bonds for different periods. The 1919-1993 period has a
lower average yield than 1946-1993 period. Taking the 1946-1993 period as a benchmark
may result in more accurate estimates as there were no significant economic turmoil post
world war II. Also, the difference between the average yields of short term and long term
gilts during this period is an insignificant 0.06%, which could be ignored. The average return
on equity during the 1946-93 period is also higher than 1919-93. Since, the WACC values are
to be used to evaluate different investment options, taking the 1946-93 period would give
us more optimistic estimates.
Change in debt-equity ratio has no significant effect on WACC. Nonetheless, there is a need
to improve the gearing in order to improve the earnings per share. To enable this, financing
of future investments should have a higher proportion of debt.
Consolidated WACC has little utility and surprisingly has a higher WACC than individual
divisional WACCs. Anyways, since Lex is not looking forward to diversification, divisional
WACCs should suffice for evaluation of investment opportunities.
The beta-value for property has been calculated as an industry average of various property
management and leasing firms. However, it should be noted that most of these real estate
firms are actively managed. Whereas, commercial property is not actively managed by Lex
and is more of a passive investment relying on capital appreciation. Although, the estimates
provide us a positive rates of return on property, it should be noted that there has been a
negative growth/depreciation of the market value over the last couple of years. The
company could try to lease out these properties in order to earn additional income.

Kaustav Dey B18088

 Lex Services PLC-Cost of Capital

FM1 Assignment

Kaustav Dey

B18088

22-10-2018

Kaustav Dey B18088

Kaustav Dey B18088