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