Case 8

Case 8 – Lex Services PLC – Cost of Capital

Questions to address by each group before presentations as well as during the presentations:

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.

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 to obtain your estimate? Justify your choice.

b. What risk premium did you use? How did you obtain this estimate?

c. 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?

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?

4) Should Lex use a single corporate-wide discount rate or multiple discount rates (one for each line of business) to evaluate investment projects? Be prepared to explain your answer. If you recommend using multiple discount rates, what rate would you use for Automative Distribution investments? For Contract Hire investments? For Property (real estate) investments?