Lex Service PLC

Duncan Baker, Robert Gage, Arlington Wade, Shelton

Cost
of Capital
Headley,
Taylor Henderson

Lex Service has recently begun to question the practices and discount rates that
they used during the process of capital budgeting. Lex hired L.E.K. Partnership to find
the appropriate discount rate to use during the budgeting process, but L.E.K. gave them
several different rates. Lex Service was concerned that its high use of equity has inflated
its cost of capital which decreased the value of the firm. Estimating their cost of capital
will play a vital role in capital budgeting decisions because it will provide them with
important data such as the required return on projects and a discount rate to find the
present value of future cash flows. Lex Services biggest question is, what discount rate
or rates should we use during capital budgeting and how will debt effect these rates? Our
recommendation for Lex is to implement more leverage in their capital structure so wacc
decreases and that Lex use the divisional weighted average cost of capital to discount
cash flows from each line of business because it provides a better estimate for
discounting cash flows.
Using the data provided, we were able to estimate a cost of equity of 16.4%. The
first step in finding the cost of equity was solving the CAPM formula. We chose a riskfree rate of 7.02%, which is the yield to maturity on long-term non-indexed U.K.
government bonds. We used a risk premium of 7.48%. The risk premium is the
difference between the average nominal returns of equities from 1919 to 1993 and the
risk-free rate. The capital asset pricing model provided a required return of 16.40% for
Lex Services (Exhibits 2 & 3). The resulting cost of equity, 16.4%, is not a fair judgment
or an appropriate discount rate for operating cash flows because it ignores additional
capital that is provided from the use of debt financing.

Operating solely with equity-supplied capital can be disadvantageous to Lex

Services for a wide array of reasons. Using only equity capital gives them a WACC of
16.4%, which is the same amount that investors require on their return for supplying
capital. The most obvious benefits of using debt financing comes from the increase in
interest which will act as a tax shield and reduce the amount of taxes paid. This can free
up more cash to payout in dividends, which will help shareholder relations. The biggest
benefit of adding debt is that it lowers the cost of capital because it has tax benefits that
make it cheaper. Increasing debt from 0% to 15% lowers the cost of capital to 14.78%
(Exhibit 3). Weighted average cost of capital has an inverse relationship to the value of
the firm and amount of debt. The more debt that is introduced, the smaller the WACC
becomes, and the value of the firm grows. The value of the firm increases because future
cash flows are discounted at the cost of capital.
While the weighted average cost of capital as of 1993, 10.02%, seems like an
appropriate discount rate, we feel that using divisional discount rates would provide a
better understanding of the companys capital cost. To find these, first we use the capital
supplied in 1993 (Exhibit 1) to find the weights of debt and equity for each segment.
Then we converted each segments asset beta to a leveraged beta so that we have a fair
comparison of WACC (Exhibit 3). Our results are as follows: Automotive Distribution
(12.22%), Contract Hire (9.12%), and Property (18.9%). The divisional costs of capital
provide more appropriate discount rates and should be used to discount future cash flows
for each respective segment.