Lex Costofcapital

Through recent several years’ asset sales, a considerable amount of capital is obtained for possible investments during 1993. On the same time, new opportunities were observed and evaluated on a regular basis. Therefore, an estimation of the cost of capital will be an essential step to help Lex to evaluate the worth of its investment opportunities, making best investment decision afterwards.

We assume that Lex will use the cost of capital estimates to evaluate long-term cash flows which include inflation and, therefore, R_F must be the non-indexed rates. Under such assumption, we could search in the Column of “Non-indexed Bonds” and Row of “Long term bonds” of Table A, then get the risk-free rate R_F = 7.2%, which we will use in the CAPM method.

Since long-term bonds chosen as a risk-free rate, we will choose 7.14%, which mostly close to 7.2%, during period of 1946 to 1993, as a new risk-free rate. Accordingly, R_M will be 16.63% during the same period of 1946 to 1993. Therefore, we could compute equity risk premium〖(R〗_M - R_F) = 9.49% based on the same time frames.

By applying CAPM formula of R_F + β(R_M – R_F) on the time point of 1993, we can easily get the company’s cost of equity of 18.9%. (β is estimated to be 1.23).

As we know un-levered beta can be defined as a production of levered equity beta and market value of equity over total market value (E/V). From exhibit 4, we get the(more detail,E=,V=,) equity-to-total capital ratio of 0.408 on market value. Then, by applying the function of un-levered asset beta (β^u = E/Vβ, the company’s un-levered asset beta could derived, which is 0.502.

If there is no debt in its capital structure, the WACC function (WACC = λ(1-t)K_D+(1-λ)K_E)could be reduced to WACC = K_E = 18.9% .