Lex Service PLC – Cost of Capital Case Solution
(a) Risk-free rate determined:
Risk-free rate is calculated as 3.7% based on average nominal return of US treasury bills, because
- It has no default risk.
- It is used as a benchmark for no risky investment.
- 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.
(b) Risk premium Estimation:
The risk premium is estimated as 9%, as Lex’s cost of equity is given 12.4%, and the risk-free rate is used 3.7% and unleveraged beta as 0.98. Based on the data, the Risk premium is calculated which shows the average historical assumption of market premium.
(c) Lex’s cost of debt:
The cost of debt is calculated as interest rate return on long-term government. Over here, Lex’s pre-tax cost debt is given as 8.4% after-tax cost of debt is computed by using tax factor that is (1-t), resulted in cost of debt of 5.6%.
Lex’s services should not use cost of capital or WACC as a discount rate for operating cash flows estimation. This is because cost of equity should be utilized for shareholders equity that shows cash in hand for shareholders after all the claims are made for creditors or any other investment. Lex’s should use appropriate cost of capital for operating cash flows estimation based on the capital structure.
ype of investments using Lex Value:
The project financing includes debt and equity of Automobile Distribution, Contract Hire, and property. The value of the project is calculated as 647.86 million pounds by using weighted average cost of capital.
|Total Capital Employed|
(NPV) is calculated as present value of future investment in a project by using WACC of 11.25%. Lex should use contract hire and automobile distribution, as an investment in Lex project.
- NPV of each project will be calculated,
- Using cash flows of each project,
- Initial Investment of each project/Net present value,
- It would result in profitable index
- High profitability index of project would be accepted, as in the case contract hire has high profitable index.
Lex’s had no debt in its capital structure, what would be its cost of capital?
If Lex has no debt in its capital structure, then the cost of capital would be equal to cost of equity because the cost of debt factor would be subtracted from total cost of capital which would help the company to calculate its enterprise value. Formula would be used as present value of future cash flows (terminal value included). In order to calculate calculateLex’s enterprise value, we need to deduct the long term debt and short term debt from the balance sheet. If Lex Services is using no leverage in its capital structure, by using tax rate 33% that resulted in the levered beta of 0.88 hence WACC resulted in 10%.
If Lex Services is not using debt in its capital structure, then the value of project become 666.08 million pounds.
Lex’s Total value after using moderate amount of debt:
The impact of using leverage can be both active and negative; it depends on the risk factor. The main advantage of using debt is tax saving, and disadvantage is higher interest to pay. It is better to invest cash in project if the yield returns more than the after-tax cost of debt. Lex’s Service is using moderate level of debt in its capital structure; it would have positive effect because cost of capital will decrease by adding the discount factor after tax cost of debt would be decreased because of tax shelter. By using moderate capital structure of 18%, tax rate 33% that resulted in a levered beta of 0.26 hence WACC resulted in 6%………………..
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