Lex Service PLC

_
Cost of Capital

Ajith Sudhakaran
B18006

Ajith Sudhakaran | B18006 | BM- A

 Case Background:

Lex service PLC is a London based automotive distribution and vehicle leasing and
financing company. Starting off as an operator of a small group of parking garages
and petrol in 1928, Lex slowly began ventured into the business of distribution
services for several European and American car manufacturers. Once it tasted
success there, Lex diversified into various geographies (United States) and also
various other sectors such as the hospitality industry as well as the electronics
components distribution. It even acquired Schweber Electronics, the 3rd largest
electronic components distributor in the USA.

However, a lull period in the early 1990s, which saw its sales in the automotive
industry take a hit forced Lex to liquidate its holdings in Schweber and refocus its
efforts on its core business of automotive distribution and leasing. Though the sales
were part cash and part equity in the buyer’s (Arrow Electronics) firm, it provided
Lex with some much needed funding. It was around the same time that Volvo had
decided to terminate its contract with Lex. Although Lex was compensated
monetarily, the share prices did face the brunt of the bad news relinquishing close
to 30% of its value.

Lex now bought the distribution rights to the distributorship of Swan National
Limited and also acquired Lucas Autocentres (auto service center operators) and
Arlington Motor Group (truck and van distributorship) In 1993. Lex also reentered
the automobile importing business by acquiring a controlling stake in the UK
division of the Korean firm Hyundai Car. Thus Lex had firmly returned back to its
operating in the sector of its core competency – automotive distribution and also
contract hiring. The former was controlled directly by Lex through its subsidiaries

Ajith Sudhakaran | B18006 | BM- A

while the latter was a joint venture with Lombard North Central PLC. Lex managed
the day to day activities of the contract hiring firm while Lombard provided the
funding to support their fleet investments.

Lex also held several investment properties that were not required fir operating
purposes which they obtained when a dealer vacated the space on outgrowing its
premises. Most of the properties were sold or were in the process of being sold so
as to raise liquidity required for the operations of Lex.

The main concern of Lex now was to estimate its cost of capital and the
methodology that was to be followed for the same. They could either take the top
down approach with a single cost of capital across divisions or multiple costs of
capital.

Financial Problems:

1. Should Lex consider just one value for cost of capital across industries or
multiple estimates of capital costs?
A. Lex should definitely consider multiple estimates of capitals costs over a
single value across industries. The former though, time consuming, would
give a far more accurate picture of what kind of projects could be deemed
feasible after considering the various realities that change from sector to
sector. The cost of capital should always be a function of the industry or use
it is invested into. Considering just one single value across divisions could
result in accepting projects of high risk (in comparison to the standards set
in that particular industry) or even rejecting risk free projects having an
Internal rate of return less than the WACC.

Ajith Sudhakaran | B18006 | BM- A

2. What are the issues/challenges associated with considering multiple
estimates of capital costs?
A. Different estimates of capital costs for different industries would require a
large number of observations and collecting the required data may be a task
in itself. Usually, firms take the pure play approach to estimate the part betas
but again the question of reliability comes into play as no two firms can be
treated to be one and the same and so their numbers will vary drastically as
well. However, taking the industrial average can mitigate this uncertainty to
some extent.

3. Is the profitability reported in 1993 an accurate measure of the turnaround

scripted by Lex PLC?
A. No. Most of the profits generated in that period is owing to the sales of the
sale of existing assets and investments. These gave rise to a one time gain
that reflected positively on the Profit and Loss statement of the firm.
However, Lex PLC did use a major portion of that money to pay off its existing
debts and also to make some new investments. Most of the new investments
were in the automotive sector which also made business sense as their core
competency lies there. Although the loss of the distribution rights of Volvo
was a major hit, the effects were partially offset by acquiring the rights to
distribute Hyundai cars across the United Kingdom.

4. Among the various rates mentioned in the case, which one is used as the risk
free rate?

Ajith Sudhakaran | B18006 | BM- A

 A. We consider the non-indexed long term rate. Non-indexed because none of

the other figures are adjusted for inflation. Long term rates are used as
equity is considered a long term investment.

Analysis

Market Market
Risk Free Rates
Returns Premium

Short Term 6.30% 16.63% 10.33%

Medium Term 6.80% 16.63% 9.83%

Long Term 7.20% 16.63% 9.43%

The short, medium and long term risk free rates have been given in the case. Long
term risk free rates have been taken into account to calculate the market premium
as equities and debt can be assumed/considered to be long term investments.
Hence, the market premium is calculated using the following formula

𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
= 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
− 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑟𝑖𝑠𝑘𝑓𝑟𝑒𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡(𝑙𝑜𝑛𝑔 𝑡𝑒𝑟𝑚)

Expected Total Expected

Average Industry Beta Equity Asset Proportion
Return Market E/V return on total
Values (E) Beta in portfolio
on Equity Value (V) market value
Automotive
189 196 0.96
Distribution 0.61 13.50% 0.588214 13.28% 3.32%
Vehicle Leasing 0.41 11.23% 99 556 0.18 0.073004 7.95% 5.65%
Property 0.68 13.61% 31 31 1.00 0.68 14.22% 0.56%
783 9.53%

Ajith Sudhakaran | B18006 | BM- A

The company operates under two broad verticals, Automotive Distribution and
contract hiring which involves vehicle leasing and financing. The average Beta
values for the corresponding industry values have been taken from exhibit 5. The
average industry betas are taken from the available information on the pure
players in the market. The values hence taken into consideration are 0.61, 0.41 and
0.68 for the automotive distribution, vehicle leasing and property industries
respectively. The average nominal return on equity for the period 1946-1993 (from
Table B) is 16.63%. This can be considered to be industry norm and market
premium is calculated from the formula as mentioned above. Now using the
following formula,

𝑅𝑠 = 𝑅𝑓 + 𝛽 (𝑅𝑀 − 𝑅𝑓 )

Where,
Rs – Investor’s expected return on a risky asset
Rf – Risk- free rate
Rm – Market rate of return

The expected return on equity on the automotive distribution, vehicle leasing and
property industries are 13.50%, 11.23% and 13.61% respectively.

The next step is to calculate the asset beta values individually for the holdings of
Lex PLC in various sectors.
𝐷 𝐸
𝛽𝐴 = ( ) 𝛽𝐷 + ( )𝛽𝐸
𝑉 𝑉

Where,

𝛽𝐴 – Asset Beta

Ajith Sudhakaran | B18006 | BM- A

𝛽𝐷 - Debt Beta
𝛽𝐸 – Equity Beta
D – Market Value of Debt
E- Market Value of Equity
V – Total market Value

The debt beta is approximated to be zero as the interest and principle payments
are considered to be fairly safe. Unless a company defaults, the bond holders are
assured of their payments. Even if the company is forced to declare bankruptcy, it
is the bond holders who are payed off before the equity share-holders are paid.
This insulates bond holders from the volatility of the market and hence bonds are
considered to be a safe investment thereby justifying the approximation of debt
beta to zero.

The asset betas of the individual business divisions have hence been calculated by
simply multiplying the E/V ratio with the equity beta. Hence the expected rate of
return on total market values are 13.28%, 7.95% and 14.22% for the automotive
distribution, vehicle leasing and property industries respectively.

Now the WACC (Weighted average cost of capital) is calculated using the following
formula:

𝐷 𝐸
𝑊𝐴𝐶𝐶 = (1 − 𝑇) ∗ 𝑅𝐷 ∗ ( ) + 𝑅𝐸 ∗ ( )
𝑉 𝑉

Where,
Ajith Sudhakaran | B18006 | BM- A
T – Tax rate
(all other terms as specified above)

From page 6 of the page we get the cost of debt [(1 − 𝑇) ∗ 𝑅𝐷 ] to be around 8.4%.
Hence the WACC amounts to 9.53% after multiplying with the respective
proportion of each sector in the overall portfolio.

Specific Recommendations and Implementations

As we can see, the overall WACC is found to be different from the expected rate of
return in individual business sectors. Therefore, employing one common cost of
capital across sectors could lead to accepting financially less viable projects and
also rejecting some of the more feasible ones. Hence it would be recommended
that they use individual costs of capital across industries and choose projects after
considering the corresponding returns in that particular industry.

Lex should also make sure that they control their debt-financing as it could raise
the cost of equity thereby increasing the cost of capital. A high cost of capital is
never desirable for any firm and Lex PLC should stay away from falling for the trap
that the low cost of debt seems to offer.

Ajith Sudhakaran | B18006 | BM- A