Luis Martins n 950

Nuno Falco n 930

Vasco Nunes n 940
Cost of Capital Cost of Capital
Cost of Capital
1. Why does Lex Service need to discuss the cost of capital
today (1993) and at a such high level?
Lex Lex Service underwent a major restructuring in its Service underwent a major restructuring in its
business lines from 1991 to 1993 (including the sale business lines from 1991 to 1993 (including the sale
of a whole Electronic division). It now holds a of a whole Electronic division). It now holds a
different portfolio of assets compared to 1991. different portfolio of assets compared to 1991.
Clearly, management thinks that the asset beta of Clearly, management thinks that the asset beta of
the company has changed, with a consequent impact the company has changed, with a consequent impact
on the cost of capital of the firm. on the cost of capital of the firm.
Once computed, the new cost of capital will enable Once computed, the new cost of capital will enable
the firm to estimate the required return on the firm to estimate the required return on
investments that replicate the firm as whole. investments that replicate the firm as whole.
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: Assuming the following premises:

E E
= 1,23 = 1,23 for for Lex Lex Services Services Stock in 1991 Stock in 1991

D D
= 0 = 0
R R
F F
= 7,2% = 7,2% (YTM on long (YTM on long- -term UK Government Bonds) term UK Government Bonds)
R R
M M
- -R R
F F
= 5,3% = 5,3% (Average for the period 1966 (Average for the period 1966- -1992) 1992)
Debt Debt- -to to- -Total Capital ratio = 37,5% Total Capital ratio = 37,5% (Midpoint between 35% and (Midpoint between 35% and
40% prevalent during the last five years) 40% prevalent during the last five years)
The cost of capital for 1991 (equity and The cost of capital for 1991 (equity and unlevered unlevered) is ) is
summarized on the following table: summarized on the following table:
1,23 1,23 ( 1 ( 1 - - 37,5% ) 37,5% )
= = 0,77 0,77

A A
7,2% + ( 5,3% ) 7,2% + ( 5,3% ) 1,23 1,23
= = 13,72% 13,72%
7,2% + ( 5,3% ) 7,2% + ( 5,3% )
A A
= = 11,27% 11,27%
Cost of Capital (Equity) Cost of Capital (Equity) Cost of Capital ( Cost of Capital (Unlevered Unlevered) )
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?
In order to correctly evaluate its future investment opportuniti In order to correctly evaluate its future investment opportunities, es, Lex Lex
Service should use: Service should use:
a single hurdle when evaluating a project that is a perfect repl a single hurdle when evaluating a project that is a perfect replica of the firm ica of the firm
as a whole, with its present divisions and weights. This could h as a whole, with its present divisions and weights. This could happen for appen for
instance, if the firm were to acquire a very similar company. instance, if the firm were to acquire a very similar company.
multiple divisional hurdles when evaluating projects that replic multiple divisional hurdles when evaluating projects that replicate one of its ate one of its
divisions; for instance, an investment in the automotive line of divisions; for instance, an investment in the automotive line of business would business would
be evaluated with the cost of capital for the automotive divisio be evaluated with the cost of capital for the automotive division. Ditto for the n. Ditto for the
other divisions. Note that the division hurdles are somewhat dif other divisions. Note that the division hurdles are somewhat different from ferent from
one another in the case of one another in the case of Lex Lex Service, and this choice will make a difference. Service, and this choice will make a difference.
Projects that aren Projects that aren t replicas of either the firms or one of its divisions should be t replicas of either the firms or one of its divisions should be
evaluated at the cost of capital specific for those projects, a evaluated at the cost of capital specific for those projects, a reflection of the reflection of the
respective betas. One may use the industry betas if they are ava respective betas. One may use the industry betas if they are available. ilable.
(1 of 2)
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?
0,46% 0,46% 10,80% 10,80% 4,28% 4,28% 24,18 24,18 Property Property
9,89% 9,89%
WACC WACC
9,37% 9,37%
10,43% 10,43%
Cost Of Capital Cost Of Capital
2 2
295,93 295,93
244,67 244,67
Divisional Market Divisional Market
Value Value
1 1
52,36% 52,36%
43,36% 43,36%
Divisional Weight Divisional Weight
Contract Hire Contract Hire
Automotive Automotive
Distribution Distribution
Line of business Line of business
4,91% 4,91%
4,52% 4,52%
Weighted Cost of Weighted Cost of
Capital Capital
1
Lex Service owns only 50% of the Contract Hire Division
1 1
As computed in question 5. As computed in question 5.
As we can see, the WACC value is similar to the cost of capital As we can see, the WACC value is similar to the cost of capital for each division. So, for each division. So,
in the particular case of in the particular case of Lex Lex Service and with its actual capital structure, the usage Service and with its actual capital structure, the usage
of WACC instead of divisions of WACC instead of divisions cost of capital would be approximately equivalent. cost of capital would be approximately equivalent.
(2 of 2)
4. Produce balance sheets at market values for each of the
three individual businesses.
Balance sheets with market values for Equity (computed from Balance sheets with market values for Equity (computed from
data and ratios presented on Exhibit 4) data and ratios presented on Exhibit 4)
Assumption: Market value for debt Assumption: Market value for debt Book value for debt Book value for debt
B = 6,40
S = 238,27 EV = 244,67
Automotive distribution
B = 457,20
S = 133,65 EV = 590,85
Contract Hire
1
B = 0,00
S = 24,18 EV = 24,18
Property
1 1
Lex Lex Service owns only 50% of the enterprise value of this division. Service owns only 50% of the enterprise value of this division.
5. What is the cost of capital for each of Lex Services
individual businesses, assuming the future target debt
ratios?
Assuming the following premises: Assuming the following premises:
The The
A A
for each of the individual businesses of for each of the individual businesses of Lex Lex is the correspondent is the correspondent
industry average industry average
A A
(from Exhibit 5) (from Exhibit 5)
Values for the target Debt Values for the target Debt- -Equity Ratios are the market midpoint values Equity Ratios are the market midpoint values
on Exhibit 6 on Exhibit 6
The cost of capital for each of individual businesses (equity The cost of capital for each of individual businesses (equity
and and unlevered unlevered) in 1993 is summarized on the following tables: ) in 1993 is summarized on the following tables:
Property Property
Contract Hire Contract Hire
Automotive distribution Automotive distribution
Line of business Line of business
R R
F F
+ ( R + ( R
M M
- - R R
F F
) )
Property Property
= 7,2% + (5,3%) = 7,2% + (5,3%) 0,68 = 0,68 = 10,80% 10,80%
R R
F F
+ ( R + ( R
M M
- - R R
F F
) )
ContractHire ContractHire
= 7,2% + (5,3%) = 7,2% + (5,3%) 0,41 = 0,41 = 9,37% 9,37%
R R
F F
+ ( R + ( R
M M
- - R R
F F
) )
Automotive Automotive
= 7,2% + (5,3%) = 7,2% + (5,3%) 0,61 = 0,61 = 10,43% 10,43%
Cost of Capital ( Cost of Capital (Unlevered Unlevered) )
(1 of 2)
5. What is the cost of capital for each of Lex Services
individual businesses, assuming the future target debt
ratios?
1,30 1,30
4,89 4,89
0,15 0,15
Debt Debt- -Equity Equity
Ratio Ratio

E E
= 0,68 = 0,68 2,30 2,30
= = 1,56 1,56

E E
= 0,41 = 0,41 5,89 5,89
= = 2,41 2,41

E E
= 0,61 = 0,61 1,15 1,15
= = 0,70 0,70

E E
1 1
Property Property
Contract Hire Contract Hire
Automotive Automotive
distribution distribution
Line of Line of
business business
R R
F F
+ ( R + ( R
M M
- - R R
F F
) )
E E
= 7,2% + (5,3%) = 7,2% + (5,3%) 1,56 = 1,56 = 15,49% 15,49%
R R
F F
+ ( R + ( R
M M
- - R R
F F
) )
E E
= 7,2% + (5,3%) = 7,2% + (5,3%) 2,41 = 2,41 = 20,00% 20,00%
R R
F F
+ ( R + ( R
M M
- - R R
F F
) )
E E
= 7,2% + (5,3%) = 7,2% + (5,3%) 0,70 = 0,70 = 10,92% 10,92%
Cost of Capital (Equity) Cost of Capital (Equity)
1 1

E E
= =
A A
( 1 + D/E ) ( 1 + D/E )
(2 of 2)