1. Lex Service PLC
Cost of Capital
Luis Martins nº 950
Nuno Falcão nº 930
Vasco Nunes nº 940
2. 1. Why does Lex Service need to discuss the cost of capital
today (1993) and at a such high level?
Lex Service underwent a major restructuring in its
business lines from 1991 to 1993 (including the sale
of a whole Electronic division). It now holds a
different portfolio of assets compared to 1991.
Clearly, management thinks that the asset beta of
the company has changed, with a consequent impact
on the cost of capital of the firm.
Once computed, the new cost of capital will enable
the firm to estimate the required return on
investments that replicate the firm as whole.
3. 2. What should cost of capital for Lex Service had been if
the company had not undergone all the recent
restructuring?
Assuming the following premises:
= 1,23 for Lex Services’ Stock in 1991
E
D=0
RF = 7,2% (YTM on long-term UK Government Bonds)
RM-RF = 5,3% (Average for the period 1966-1992)
Debt-to-Total Capital ratio = 37,5% (Midpoint between 35% and
40% prevalent during the last five years)
The cost of capital for 1991 (equity and unlevered) is
summarized on the following table:
Cost of Capital (Unlevered) Cost of Capital (Equity)
A
1,23 ( 1 - 37,5% ) 7,2% + ( 5,3% ) 1,23
7,2% + ( 5,3% ) A
= 0,77 = 11,27% = 13,72%
4. 3. In order to value future investments should the
company use a single hurdle or multiple divisional hurdles?
Will that make a significant difference in this case? (1 of 2)
In order to correctly evaluate its future investment opportunities, Lex
Service should use:
a single hurdle when evaluating a project that is a perfect replica of the firm
as a whole, with its present divisions and weights. This could happen for
instance, if the firm were to acquire a very similar company.
multiple divisional hurdles when evaluating projects that replicate one of its
divisions; for instance, an investment in the automotive line of business would
be evaluated with the cost of capital for the automotive division. Ditto for the
other divisions. Note that the division hurdles are somewhat different from
one another in the case of Lex Service, and this choice will make a difference.
Projects that aren’t replicas of either the firms or one of its divisions should be
evaluated at the cost of capital specific for those projects, a reflection of the
respective betas. One may use the industry betas if they are available.
5. 3. In order to value future investments should the
company use a single hurdle or multiple divisional hurdles?
Will that make a significant difference in this case? (2 of 2)
Divisional Market Weighted Cost of
Cost Of Capital2
Line of business Divisional Weight
Value1 Capital
Automotive
244,67 43,36% 10,43% 4,52%
Distribution
Contract Hire 295,93 52,36% 9,37% 4,91%
Property 24,18 4,28% 10,80% 0,46%
9,89%
WACC
As we can see, the WACC value is similar to the cost of capital for each division. So,
in the particular case of Lex Service and with its actual capital structure, the usage
of WACC instead of divisions’ cost of capital would be approximately equivalent.
1 LexService owns only 50% of the Contract Hire Division
1 As
As computed in question 5.
6. 4. Produce balance sheets at market values for each of the
three individual businesses.
Balance sheets with market values for Equity (computed from
data and ratios presented on Exhibit 4)
Assumption: Market value for debt Book value for debt
Automotive distribution Contract Hire1 Property
EV = 244,67 S = 238,27 EV = 590,85 S = 133,65 EV = 24,18 S = 24,18
B = 6,40 B = 457,20 B = 0,00
1 Lex
Lex Service owns only 50% of the enterprise value of this division.
7. 5. What is the cost of capital for each of Lex Service’s
individual businesses, assuming the future target debt
(1 of 2)
ratios?
Assuming the following premises:
The A for each of the individual businesses of Lex is the correspondent
industry average A (from Exhibit 5)
Values for the target Debt-Equity Ratios are the market midpoint values
on Exhibit 6
The cost of capital for each of individual businesses (equity
and unlevered) in 1993 is summarized on the following tables:
Line of business Cost of Capital (Unlevered)
RF + ( RM - RF ) Automotive
Automotive distribution
= 7,2% + (5,3%) 0,61 = 10,43%
RF + ( RM - RF ) ContractHire
Contract Hire
= 7,2% + (5,3%) 0,41 = 9,37%
RF + ( RM - RF ) Property
Property
= 7,2% + (5,3%) 0,68 = 10,80%
8. 5. What is the cost of capital for each of Lex Service’s
individual businesses, assuming the future target debt
(2 of 2)
ratios?
Line of Debt-Equity
Cost of Capital (Equity)
1
E
business Ratio
E= 0,61 1,15 RF + ( RM - RF )
Automotive E
0,15
distribution = 0,70 = 7,2% + (5,3%) 0,70 = 10,92%
E= 0,41 5,89 RF + ( RM - RF ) E
Contract Hire 4,89
= 2,41 = 7,2% + (5,3%) 2,41 = 20,00%
E= 0,68 2,30 RF + ( RM - RF ) E
Property 1,30
= 1,56 = 7,2% + (5,3%) 1,56 = 15,49%
= ( 1 + D/E )
1
E A
