BA 5802 Financial Management Case Study 2
Emre BULUT Lex Service PLC – Cost of Capital
1. Why is Lex Service PLC concerned about its cost of capital in 1993? What role will an estimate of the cost of capital play within Lex? In general, how can and do companies make use of cost of capital estimates? Since there are significant changes in the company for the last 3 years such as descending trend in car and truck market in 1991, sale of one of their core electronics business, terminated Volvo agreement etc.; the company thinks that their financial value (equity and debt ratios and weights) and accordingly cost of capital is changed. Also company has free cash (derived from the sales of electronics division, termination of Volvo contract and disposable properties) to invest in different projects. Cost of capital (WACC) is main determinant for future cash flows in any investment in the future. WACC is used to make decisions which involve raising and investing new capital in forms of debt or equity.
WACC determines the hurdle rate and makes easier to evaluate future projects whether profitable or not. 2. Using the data provided in the case, estimate Lex’s cost of equity under its future target capital structure for the consolidated company. Cost of equity can be calculated in 3 different ways (1) CAPM, (2) DCF, (3) Own-Bond-Yield-Plus-Judgemental-Risk Premium. CAPM will be used in this study since we have idea about market premium and risk free rates. Re=rf +(rm– rf) * β
Re = The required rate of return on equity
rf = The risk free rate
(rm – rf )= The market risk premium
β = Risk coefficient
rf = 7.2 %
rm = 14.68 %
Re= 7.2 + (14.68-7.2)*1.23 = 16.4 %
a. What risk-free rate did you use to obtain your estimate? Be prepared to justify your choice. As risk-free rate 7.2 % is used since it is long term government treasury bond rates and it is assumed that government always pays and no bankruptcy...
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