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 the cost of capital estimates?
Lex Service PLC cost of capital in 1993:

 Following on different resources transfers, Lex had arranged for the impressive measure
of money, which the company was seen to reinvest in new businesses. For this reason, the
company is required to exact evaluations of its expense of capital and each of its divisions'
expense of capital to assess speculations and boost capital budgeting decisions.
 Secondly, the company was a significant holder of property, and resources were not
required for operating purposes some of which were needed to be discarded within the
year. For this reason, the company is required to proper discount rate with a specific end
goal to value adequately such assets.

Role of cost of capital:

The cost of capital plays an important role in the analysis of capital budgeting model. It
helps to cover the cost of invested funds by using an appropriate cost of capital. It has
importance in making the financial decision to evaluate the return on the investment in the
company.
Estimation of cost of capital:

(1)Give organizations an approach for their expense of financing. (2) Act as a measure to
be minimized to locate their most ideal capital structure, and (3) COC can be utilized as an
obstacle rate for speculation decisions. In capital budgeting undertakings are in reality
assessed either by discounting future money streams to the present by the obstacle rate, in
order to determine the net present value of the venture, with a positive NPV the project is
worth to take, or by computing the internal rate of return (IRR) on the task and comparing
this to the obstacle rate if the IRR surpasses the obstacle rate, the task would move ahead
or it would be accepted.

2) Using the data provided in the case, estimate Lex’s cost of equity under its future
target capital structure for the consolidated company. What risk-free rate did you use
to obtain your estimate? Justify your choice. What risk premium did you use? How
did you obtain this estimate? Is your estimate of Lex’s cost of equity appropriate as a
discount rate for Lex’s total operating cash flows? Why or why not?

CAPM:

Rs = 7.2%+1.23(7.94%) = 16.97%
 Estimate of risk free rate:

Risk-free rate is calculated as 3.7% based on average nominal return of US treasury bills.

• Risk free rates are the current yields on default free government securities.

• Cost of capital estimates used to evaluate long term cash flows, choose the
government bonds with the longest maturity.

• Inflation risk is eliminated.

• It helps to minimize the interest rate risk and reinvestment risk for especially
companies like Lex service, which has highest growth opportunities.

Market risk premium estimate is the difference between historical expected return on
market portfolio and historical risk free rate. Assumptions took for this are,

• Risk free rate is historical average on medium and long term government securities.

• Expected return on the market portfolio is the long term average risk on market
equities.

Calculated cost of equity of 16.97% does not reflect impact of debt in Lex’s capital
structure. Not an appropriate measure to discount Lex’s operating cash flows. The cost of
equity should be used to discount cash flows to equity which is the cash available to the
shareholders after all expenses, reinvestment and debt repayment. To discount its operating
cash flows or free cash flows to the firm, Lex should use its cost of capital, based on its
target capital structure.

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
effect its total value? How might we capture this value impact of debt in our valuation
analysis?

In the case of unlevered firms,Market value risk and cost of capital for the firm’s equity
are equal to the corresponding amount of assets.

• If Lex had no debt in its capital structure, its cost of capital would be to its cost of equity.
The same will be its enterprise value
• To get Lex”s enterprise value, substract net debt and other long term obligations from the
estimated value.
• Long term obligations include off balancesheet items, pension deficits etc..

The nature of the impact depends upon the risk profile of the firm.Moving from no leverage to
a moderate leverage will have a positive impact on the firms value assuming money invested
in profitable ventures

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 Contract Hire Investments? For Property (real assets)
investments?

Because the risk of each project Lex might consider will vary owing to different systematic
risk and different capital structures, Lex should use different discount rates to calculated
their NPV and decide between them