Lex service Plc sold its various subsidiaries and other assets in between 1991 and 1993 which provides more than £340 million of funds. To reinvest this huge amount of funds it evaluates many investment options and acquisitions. To evaluate the worth of new investments, Lex uses discounted cash flow analysis. In order to employ DCF analysis method, discount rate or cost of capital required. Now the question is arises ‘what should be real cost of capital’. Case Analysis:
After a long series of acquisition and divestment, Lex service Plc’s businesses remains to consist only two fundamental halves: * Automotive distribution
* Contract hire (vehicle leasing and finance)
In addition to these operating halves, Lex was also a substantial holder of property which was further reclassified as investment properties. Method of calculating cost of capital:
Most prominent method of calculating cost of capital is CAPM (capital asset pricing model). One important point here is that as company was utilizing both debt and equity as its source of funds then we calculate WACC (weighted average cost of capital) instead of simple cost of capital.
Calculating weighted average cost of capital:
In CAPM model we need estimates for following items:
1. Risk free rate:
Generally a return on long term government bonds is treated as risk free rate because relatively no risk is associated with government bonds. So here we take return on Non-indexed long term government bonds as risk free rate for our purpose of calculating cost of capital. That is: 7.2% 2. Expected return on market portfolio:
This is calculated by analyzing historic data of returns on the market portfolio. For our purpose we take average annual return on equities of period ranging from 1919 to 1993 as expected return on market portfolio. That is: 14.68% 3. Risk free rate for calculating market risk premium:
As we take period of 1919 to 1993 for...