Lex Service Plc- Cost of Capital

Introduction – This is case about a corporate named Lex Service PLC which was incorporated in 1928 as Lex Garage Limited in London. In 1945 they expanded through acquisitions of various British, European and American Car manufactures. In 1950 they obtained exclusive franchise of Volvo to import and distribute Volvo cars in United kingdom. In 1970 they diversify into other service business by acquisitions. Now they have major line of business as Automotive Distribution and Contract hire.

Now the import agreement with Volvo is ended early and they got 100 million ponds. They also have sold their shares from arrow electronic, so they have capital for investment and for investment in new project they are in need of knowing cost of capital.

Assumptions—

1.Risk free rates are current yields on default-free government securities.

2. Cost of capital estimate is used to evaluate long term cash flows and so I have taken government bonds with longest maturity for taking.

3.As the Lex cash flow includes inflation so I have chosen non-index bonds ie 7.2% as Risk free rate . (TABLE A)

4.Expacted return on the market portfolio is the long term average risk on market equities. So equity risk premium can be considered as (Rm-Rf) = 14.68 – 6.74 = 7.94 %. (TABLE B)

Now since each line of business (division) carries different amount of risk and the cost of capital so they should be accounted differently to reflect each division risk and capital structure.

Scenarios--------

1. Consolidated company wide discount Rate

Using CAPM investor’s expected return Rs = Rf + B (Rm-Rf)

Rf= 7.2% , B= 1.23 , (Rm-Rf) = 7.94%  Rs=7.2%+1.23*7.94% = 16.97%

As this calculated cost of equity does not reflect impact of debt in Lex’s capital structure.

And WACC = (E/V) * Ke + (D/V) *Kd*(1-t)

So present unleveraged scenario WACC= 100% *Ke = 16.97%

2. Considering Debt Leverage

A.company wide discount rate

WACC= Ke*(equity/Debt+equity)+Kd*(Debt/Debt+equity)*(1-corporate tax rate)...