1. Why is Lex Service PLC concerned about its cost of capital in 1993?

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?
Main points:
 Cost of capital is the required return necessary to make a capital budgeting project
worthwhile.
 Import agreement with Volvo ended early.
 100 million pounds cash payment to Lex of
 Future growth initiative
The reason why Lex Service PLC is concerned about its cost of capital in 19993 is due to them
selling various if subsidiaries and other assets, which have provided Lex with more than 340 million
pounds. These 340 million pounds has been utilised to making new acquisitions in of 132.5 million
pounds and used about 197 million pounds to repay debt leaving them with a much smaller
financial leverage compared to the years earlier and changing the cost of capital. Now with the
change in their cost of capital Lex does not know with discount rate they should use to discount
their cash flow with to evaluate the worth if its investment opportunities and what rate of return to
demand on its investments. In addition, their import agreement ended earlier than expected with
Volvo. Upon relinquishing the franchise to Volvo, Lex realized 100 million pounds for the value in
the concession.

The role an estimated of the cost of capital will play within Lex is large because it will impact all
the cash-flows with how much or little it will be discounted. In the case Lex finds out the cost of
capital is much higher than expected it can make the investment they just have made worse than
expected. It will also be necessary to know it in case of them making new investment where it will
be value to know which synergies effect expected to make the investment a success or purchasing
price of the company/asset. In other words how the can use the new capital to grow the company
and make good investments. Every company uses the cost-of-capital estimate to value future
investment opportunities to see what purchasing price premium will impact the future cash-flows
and what the purchasing price need to be for the investment to be profitable and capital budgeting.

2. Using the data provided in the case, estimate Lex’s cost of equity under its future target
capital structure for the consolidated company.
 a. What risk-free rate did you use to obtain your estimate? Justify your choice.
To find the risk-free rate I have utilised the information from Table A “Prevailing Yields to Maturity
on U.K. Government Bonds, September 1993 - where I have chosen the long-term bonds with an
interest rate of 7.2% as my risk-free rate. Risk-free rates are the current yields in default-free
government securities and do the timeline of many of Lex’s investment. I have chosen the
government bond with the longest maturity to evaluate long-term cash-flows and the non-indexed
bonds due to inflation will be included in Lex’s cash-flows - the other number we get are nominal.
b. What risk premium did you use? How did you obtain this estimate?
To find the risk-premium you would take the historic return of long-term bonds and equity over as
long a time period as possible due to the economy have period with low and negative returns and
period with positive and high return which needs to be accounted for. In September 1991, Lex sold
its electronics businesses to Arrow Electronics, meaning they no longer had as much business in the
US and therefore to find the risk-premium we will only use the information about the UK markets
as Lex will not that highly be impacted on the development in the US economy.
Table B says the return on the Medium- to long-term gilts is equal to 6.74% and equities is equal to
14.68%, which means we can find the market risk premium.
Market risk premium=r m−r f
Insert values:
r m −r f =14.68 %−6.74 %=7.94 %
The reason for using the longest period is that the standard deviation is smaller out of the periods
and is does not say anything which one is correct. In addition, we also know that using a longer
period will result in a lower standard deviation which can be used to find the standard error.
St . dev
standard error=
√ Obs
Where the number of observations would be the years in the period.
Beta on equity:
We have been given the information that the beta on equity is equal to 1.23, but we need to take into
account the debt levels which has been used to achieve this beta level. The debt to capital level there
has been used to find this beta on asset is equal to 35-40%, where I would choose to use the
midpoint - 37.5%. In addition, we have been given the target capital structure in exhibit 6 where the
target debt to equity level is 12% to 24% where we will be using the midpoint again 18%. Now we
want to go from debt to equity to debt to value, which can be done with the following formula:
 D
D E 0.18
= = =15.25 %
V
1+ ( )
D
E
1+0.18

This means we need to find the beta on assets with the “historic debt levels”. I will assume that the
beta on debt is equal to 0, which means we can write the beta on equity as the following equation:
β D∗D β E∗E
β A= +
V V
β E∗E
β A=
V
Inserting values:
β A=1.23∗( 1−0.375 )=0.76875
The beta on assets will not change and there we need to find the beta on equity with the target
capital structure and we can rewrite the following equation:
β A∗V
=β E
E
Insert values:
0.76875∗1
=0.907
( 1−0.1525 )
Now we have found the beta on equity with the use target capital structure is the following:
β E =0.907
Now we can use the CAPM formula to find the cost of equity:
CAPM : R E=r f + β E ( r m−r f )
Insert values and we get:
R E=7.2 % +0.907∗7.94 %=14.40 %
c. Is your estimate of Lex’s cost of equity appropriate as a discount rate for Lex’s free
cash flow? Why or why not?
No, my estimate of Lex’s cost of equity is not appropriate as a discount rate for Lex’s free cash flow
and the reason for this is that we have not considered the capital structure for the company and how
it will change in the future. In addition, we see from exhibit 4 that the capital structure of the
different part of Lex is very different which also need to be accounted for.

3. 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 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?
We can use the following formula to find what the cost of capital:
CAPM=R A=R f + β A (R m−r f )
Insert the values - We still assume that the risk-free rate and market risk premium is the same:
r f =7.2 %
Market risk premium=r m−r f =7.94 %
And the asset beta we found was equal to 0.76875 . Now inserting values:
Cost of capital =R A =7.2+ 0.76875∗7.94=13.303875 %
It would be possible to find the value of Lex with use of the following formula:
PV FCF + PV terminal value
Where we have been using the WACC/cost of equity as the discount rate to find the PV value of
FCF and terminal value.

Now we will look at the difference between total value of lex in the case of adding a moderate
amount of debt compared to no debt as we just have assumed. In addition, we have been given the
target capital structure in exhibit 6 where the target debt to equity level is 12% to 24% where we
will be using the midpoint again 18%. Now we want to go from debt to equity to debt to value,
which can be done with the following formula:
D
D E 0.18
= = =15.25 %
V
1+ ( )
D
E
1+0.18

The text says the cost of debt is equal to 8.4% before taxes, which we are been informed is equal to
33%. Now we just need to insert the values in the WACC formula:
E R D∗D
WACC = ∗R E + ∗( 1−T )
V V
Insert values:
WACC =(1−15.25 %)∗14.40 %+ 8.4 %∗15.25 %∗( 1−0.33 )=12.62 %
And we will value Lex in the same way again with following formula
PV FCF + PV terminal value
Where we have been using the WACC/cost of equity as the discount rate to find the PV value of
FCF and terminal value. We can see that now with debt is the discount rate smaller which means
that value of the PV FCF and terminal value is higher resulting in a higher value of Lex.

How would a change in leverage typically impact the firm?

APV model:
 Interest tax shield
 Bankruptcy cost
 Agency cost

Adjusted Present value formula => APV unlevered firm value + PV of tax benefits.

4. Should Lex use a single corporate-wide discount rate or multiple discount rates (one for
each line of business) to evaluate investment projects? Explain your answer. If you
recommend using multiple discount rates, what rate would you use for Automotive.
Distribution investments? For Property (real estate) investments?
I would recommend using multiple discount rates and the reason for this is that the different part of
Lex is using different debt to equity levels, which means that the return on equity will be different
between the different divisions. The reason for this is that investors would like to be compensated
for increased risk and with higher debt levels comes higher debt levels. Besides the debt levels is
there also different risk associated with different industries which need to be accounted for one way
or another. The easiest way to do that is to use the beta of industry.

First, we need to find the cost of equity for the automotive part of Lex where we will be using the
CAPM model. We still assume that the risk-free rate and market risk premium is the same:
r f =7.2 %
Market risk premium=r m−r f =7.94 %
Now we just need to find the beta on automotive industry - where we can use exhibit 5 which says
that the beta assets on the automotive distribution is on average equal to 0.61. This means we need
to find the beta on equity. I will assume that the beta on debt is equal to 0, which means we can
write the beta on equity as the following equation:
 β D∗D β E∗E
β A= +
V V
β E∗E
β A=
V
E
We know that is equal to the following:
V
In addition, we have been given the target capital structure in exhibit 6 where the target debt to
equity level is 8% to 21% where we will be using the midpoint again 18%. Now we want to go
from debt to equity to debt to value, which can be done with the following formula:
D
D E 0.15
= = =13.04 %
V
1+ ( )
D
E
1+0.15

Which means we can isolate for beta on equity and get the following equation where we just need to
insert values:
V
∗β A=β E
E
Insert values:
1
∗0.61=0.7015
(1−0.1304)
Now we can use the CAPM formula to find the cost of equity:
CAPM : R E=r f + β E ( r m−r f )
Insert values and we get:
R E=7.2 % +0.7015∗7.94 %=12.77 %
We can use the following formula to find what the cost of capital:
E R D∗D
WACC = ∗R E + ∗( 1−T )
V V
The text says the cost of debt is equal to 8.4% before taxes and we do not change because the target
debt level is the same and we do not get that much information. Taxes are been informed to be equal
to 33%. With the information in exhibit 4 we can find the debt-to-value ratio and the equity-to-value
ratio.
WACC =(1−0.1304)∗12.77 %+8.4 %∗0.1304∗( 1−0.33 )=11.95 %
Now we just need to do the same for the other parts of Lex.
Now we will find the cost of equity for the contract hire part of Lex where we will be using the
CAPM model. We still assume that the risk-free rate and market risk premium is the same:
r f =7.2 %
Market risk premium=r m−r f =7.94 %
Now we just need to find the beta on contract hire - where we can use exhibit 5 which says that the
beta assets on the contract hire is on average equal to 0.41. This means we need to find the beta on
equity. I will assume that the beta on debt is equal to 0, which means we can write the beta on
equity as the following equation:
β D∗D β E∗E
β A= +
V V
β E∗E
β A=
V
E
We know that is equal to the following:
V
In addition, we have been given the target capital structure in exhibit 6 where the target debt to
equity level is 489% to 489% where we will be using the midpoint again 489%. Now we want to go
from debt to equity to debt to value, which can be done with the following formula:
D
D E 4.89
= = =83.02 %
V
1+( )
D
E
1+ 4.89

Which means we can isolate for beta on equity and get the following equation where we just need to
insert values:
V
∗β A=β E
E
Insert values:
1
∗0.41=2.4149
1−0.8302
Now we can use the CAPM formula to find the cost of equity:
CAPM : R E=r f + β E ( r m−r f )
Insert values and we get:
R E=7.2 % +2.4149∗7.94 %=26.37 %
We can use the following formula to find what the cost of capital:
 E R D∗D
WACC = ∗R E + ∗( 1−T )
V V
The text says the cost of debt is equal to 8.4% before taxes, which we are been informed is equal to
33%. With the information in exhibit 4 we can find the debt-to-value ratio and the equity-to-value
ratio.
WACC =(1−0.8302)∗26.37 %+ 8.4 %∗0.8302∗( 1−0.33 )=9.85 %
Now we just need to do it for Property part (real estate), which is a bit easier because of having no
debt which means that the asset beta will be equal to the equity beta and the cost of equity is equal
to the WACC.
We still assume that the risk-free rate and market risk premium is the same:
r f =7.2 %
Market risk premium=r m−r f =7.94 %
Now we just need to find the beta on property - where we can use exhibit 5 which says that the beta
assets on the property is on average equal to 0.68. This means we need to find the beta on equity. I
will assume that the beta on debt is equal to 0, which means we can write the beta on equity as the
following equation:
β D∗D β E∗E
β A= +
V V
β E∗E
β A=
V
In addition, we have been given the target capital structure in exhibit 6 where the target debt to
equity level is 130% to 130% where we will be using the midpoint again 130%. Now we want to go
from debt to equity to debt to value, which can be done with the following formula:
D
D E 1.30
= = =56.52 %
V
1+( )
D
E
1+1.30

Which means we can isolate for beta on equity and get the following equation where we just need to
insert values:
V
∗β A=β E
E
Insert values:
1
∗0.68=1.5939
1−0.5652
Now we can use the CAPM formula to find the cost of equity:
CAPM : R E=r f + β E ( r m−r f )
Insert values and we get:
R E=7.2 % +1.5939∗7.94 %=19.855 %
We can use the following formula to find what the cost of capital:
E R D∗D
WACC = ∗R E + ∗( 1−T )
V V
The text says the cost of debt is equal to 8.4% before taxes, which we are been informed is equal to
33%. With the information in exhibit 4 we can find the debt-to-value ratio and the equity-to-value
ratio.
WACC =(1−0.5652)∗19.855 %+ 8.4 %∗0.5652∗( 1−0.33 )=12.29 %
Now we just need to do it for Property part (real estate), which is a bit easier because of having no
debt which means that the asset beta will be equal to the equity beta and the cost of equity is equal
to the WACC.