Lex Service PLC

Cost of Capital Multiple Wide Discount Rate

This will Overvalue or Undervalue the company Single Wide

Discount Rate Multiple Wide

Discount Rate Multiple Wide

Discount Rate

-It will ensure the company is valued properly

- It will protect the interest of the stockowners

-It will encourage future investment into the company The Right

Choice? WACC= Wdcostd +Wecoste

Wd+We=1 and Wd=0, so We=1

WACC=0+1*coste

WACC=coste If Lex had no debt in its capital structure, what would its cost of capital be?

-Single wide Discount Rate

-Multiple wide Discount Rate

-Appropriate rates should be used

according to the business lines

-Each division carries on different

amount of risk and the cost of capital

should be accustomed to reflect each

risk and capital structure -CONS

-Most firms raise money in bulk for the entire company. So tracing individual investments for individual projects would be difficult.

-Financing costs depends on the risk of the firm, not the risk of a specific project.

-The equity holder has claims on the whole company, not just one particular project. Multiple Wide Discount Rate Cost of capital is calculated by the weighted

average cost of capital (WACC) formula, which is:

WACC= Wdcostd + Wecoste

Wd : weight of debt

costd : cost of debt

We: weight of equity

coste : cost of equity Should Lex use a single-wide corporate wide discount rate or multiple discount rates to evaluate investment projects? -PROS:

-Multiple discount rates are consistent with finance theory suggesting that such a discount rate will reflect the individual risk of the each investment. Multiple Wide

Discount Rate • With the information given and the tables in

the case CAPM is the best way to get Lex’s

estimate cost of equity.

• The CAPM:

Rs = Rf + β * (Rm – Rf) What risk-free rate did you use to

obtain your estimate? What risk premium did you use?

How did you obtain this estimate? Using the data provided in the case, estimate Lex's cost of equity under its future target capital structure for consolidated company. Risk Premium Rm = 14.68% Rf = 6.74%

Rp = Rm – Rf

Rp = 14.68 – 6.74

Rp = 7.94% Is your estimate of Lex's cost of equity appropriate as a discount rate of Lex's total operating cash flow?

Why or why not? CAPM: Rs = Rf + β * (Rm – Rf)

Rf = 7.2% β = 1.23 Rm = 14.68% Rf = 6.74%

Rs = 7.2 + 1.23 (14.68-6.74)

Rs = 16.9662 WACC Why is Lex Service PLC

concerned with its

cost of capital in 1993? In general, how can and do

companies make use

of cost of capital estimates? What role will an

estimate of cost of

capital play within Lex? Lex had a loss of 3 million in 1991

Volvo ended its 33 year agreement with Lex 1992

Lex sold near all of its share in Arrow Electronics Lex had a loss of 3 million in 1991

Volvo ended its 33 year agreement with Lex 1992

Lex sold near all of its share in Arrow Electronics - Lex had a loss of 3 million in 1991

-Volvo ended its 33 year agreement with Lex 1992

-Lex sold near all of its share in Arrow Electronics

-The decision will greatly affect

the company’s value in taking on

additional projects. Dilemma? Cost of capital= WACC

Lex used WACC as the discount rate to determine NPV of project

WACC can be used also to compare to the IRR of each project -Cost of capital= WACC

-Lex used WACC as the discount rate to determine NPV of project

-WACC can be used also to compare to the IRR of each project -Cost of capital estimates allow the company to calculate NPV of project and compare with IRR

-Allows to evaluate the riskiness of a project

-Use it as an opportunity cost If Lex operated with essentially no leverage in its capital structure and then added a moderate amount of debt, how would this affect its total value? Some effects that are changed by and addition of debt:

-Firm value

= PV FCF + PV Continuation Value + PV Interest Tax Shield

- WACC

= wdcostd + wecoste If Lex added a large

amount of debt… Problems

- Financial difficulties in repaying

- Worry anyone dealing with

the company Veronica Zermeno

Erik Pena

Michelle Aleman

Uyen Hoang

Jonathan Cruz

Kendra Thaler

Chau Tran C

A

S

E

5 To calculate the discount rates, we use the Weighted Average Cost of Capital(WACC).

Discount Rate (WACC) = (Weight of Debt x Cost of Debt) + (Weight of Equity x Cost of Equity or CAPM) What rate should we use? What rate should we use?

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# FIN321 Cost of Capital

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