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Lex Service has recently begun to question the practices and discount rates that
they used during the process of capital budgeting. Lex hired L.E.K. Partnership to find
the appropriate discount rate to use during the budgeting process, but L.E.K. gave them
several different rates. Lex Service was concerned that its high use of equity has inflated
its cost of capital which decreased the value of the firm. Estimating their cost of capital
will play a vital role in capital budgeting decisions because it will provide them with
important data such as the required return on projects and a discount rate to find the
present value of future cash flows. Lex Services biggest question is, what discount rate
or rates should we use during capital budgeting and how will debt effect these rates? Our
recommendation for Lex is to implement more leverage in their capital structure so wacc
decreases and that Lex use the divisional weighted average cost of capital to discount
cash flows from each line of business because it provides a better estimate for
discounting cash flows.
Using the data provided, we were able to estimate a cost of equity of 16.4%. The
first step in finding the cost of equity was solving the CAPM formula. We chose a riskfree rate of 7.02%, which is the yield to maturity on long-term non-indexed U.K.
government bonds. We used a risk premium of 7.48%. The risk premium is the
difference between the average nominal returns of equities from 1919 to 1993 and the
risk-free rate. The capital asset pricing model provided a required return of 16.40% for
Lex Services (Exhibits 2 & 3). The resulting cost of equity, 16.4%, is not a fair judgment
or an appropriate discount rate for operating cash flows because it ignores additional
capital that is provided from the use of debt financing.