Flight Plan Consulting, Inc. (A) Historical (Book) Cost of Capital Bill Gibson b
ID: 1171889 • Letter: F
Question
Flight Plan Consulting, Inc. (A)
Historical (Book) Cost of Capital
Bill Gibson began Flight Plan Consulting, Inc. (FPC) in 1990. The company offered very specialized consulting services to corporate flight departments. That is, to those companies that have their own planes for purposes of executive transportation. Such consultancy related to the cost versus benefit considerations of the acquisition and use of corporate aircraft. Bill Gibson was ideally suited for this line of endeavor; he was both a commercial pilot and had held an adjunct position as a finance professor in a university near his home. His company had its first and only public offering of stock in 1995, at that time revenue had reached the $5 million dollar mark and the employee headcount was up to ten.
The Company
In the twelve years since the company's inception, sales, earnings and the company's fine reputation have increased steadily. The company's financial statements, and selected capital market and industry data and information are provided in Exhibits 1-3. A major contributor to the company's good fortunes is a particular area of concern taking place in many corporate flight departments around the United States. That concern is known as 'fractional ownership' versus full ownership of corporate aircraft. Gibson, while not a corporate pilot, understood well the costs, benefits, concerns and industry dynamics of corporate flight departments and the companies that supplied the aircraft. This knowledge and breadth of understanding formed the basis for his consulting company.
Fractional ownership, in its simplest terms, is when several companies, usually three or four companies, share the ownership of a corporate aircraft. One web site dedicated to fractional ownership described the arrangement as 'similar to condominium time sharing'. That description may oversimplify the situation, however, there are similarities. For example, a company who wishes to buy fractional ownership will buy or lease a 1/5th interest in an airplane. Such an arrangement would allow for approximately160 hours per year of usage. The total cost would depend upon the type of aircraft chosen. The fractional purchaser or lessee would also have access to aircraft crew, maintenance and everything else needed to complete the operation of a corporate aircraft.
The interest in fractional ownership has several origins, the most prominent of which is the corporate 'downsizing' and 'rightsizing' of the decade of the 1990's. The closing of a corporate flight department could possibly mean a significant reduction in total corporate overhead expenses. Moreover, the fractional ownership may be more 'flexible' in the manner in which the services are customized for each individual fractional owner. A rule of thumb among consultants was if the aircraft will be needed between 100 and 350 hours per year fractional ownership would likely be the best option. (The other options being, for less than 100 hours per year, use a charter service; for usage over 350 hours per year, operate an in-house flight department.)
Within that environment FPC has become a major source of consulting services for firms that are moving from having an in-house flight department to fractional ownership, or considering corporate aircraft acquisition for the first time. The operations of FPC involved Gibson or one of his five consultants working with the client to determine the most efficient manner in which to acquire the usage of a corporate aircraft. The consulting relationships were always quite involved and of long duration. A consultant's reputation, however, depended upon the word-of-mouth goodwill of each client.
In the last year or so, Gibson had considered expanding by acquisition. There were several smaller consultancies in the same line of business as FPC. Gibson, after extensive discussions with his investment bank, had decided to focus upon two firms. Either one of those two would permit him to immediately acquire clients in Canada and Germany. The more pronounced international reach was exactly what FPC's strategic plan called for. While the company had done business in both Canada and parts of Western Europe for several years, the companies being considered for acquisition had very positive reputations in their respective locations.
Gibson believed that long-term capital from external sources would be needed not only to finance the acquisition, but for any future expansion the company might consider. While the capital markets in the U.S., especially the equity market, was not as high in its valuation of common stocks as in the recent past, Gibson believed FPC's common stock to be valued fairly at present. He also believed that the company's excellent bond rating would make a debt issue feasible.
The investment bankers informed Gibson that it would be important, if equity were issued, to achieve a wider geographic dispersion of the company's stock. The bankers believed that this would more solidly establish the equity in the capital markets, and could only serve the company in a positive manner for subsequent equity or debt issuances. At this point in the discussion one of the company's board members began to raise questions concerning the firm's plans to raise external funds. This board member, a physician, wondered how the company acquired by FPC would be valued, that is how would its economic worth be determined, and what relationship that valuation process would have with FPC's present capital structure and its cost of capital. The physician admitted to having 'only rudimentary knowledge of finance,' as he put it, but he was an avid observer of the financial environment and knew that there was some relationship among the items he had mentioned. It was at that time that Gibson decided that he had better provide some specific and detailed information to his board concerning the company's cost of capital and its relationship to the valuation process.
In order to move the process along, Gibson decided to hand over the task of preparing a draft of 'the cost of capital memo', as it had come to be called, to Kay Riddle. Kay was a summer intern employed in FPC's controller's office. She was a college senior and planned to graduate at the end of the fall semester as a finance major. Kay believed that a credible job on the memo would increase her chances of joining the firm upon graduation. Moreover, she knew that Gibson has scores of contacts in various areas of finance around the country. He was a good person to know. To construct her memo Kay wondered how she, in relatively few words, could best show the interrelationship among the firm’s balance sheet, specifically the capital structure, the yield on the firm’s debt, and the rate of return on the firm’s equity. All of that information would be a starting point for her explanation!
Exhibit 1
Flight Plan Consulting, Inc.
Sales and Earnings Trend
Year
Sales
Net Income After-Tax
EPS
1992
$2,000,000
$240,000
$0.60
1993
2,750,000
338,000
0.84
1994
3,200,000
384,000
0.96
1995
5,000,000
575,000
1.44
1996
5,700,000
600,000
1.50
1997
6,200,000
713,000
1.78
1998
7,300,000
803,000
2.00
1999
8,500,000
860,000
2.15
2000
9,100,000
900,000
2.25
2001
10,300,000
912,720
2.28
Exhibit 2
Flight Plan Consulting, Inc.
Balance Sheet
December 31, 2001
($000’s)
Current Assets
$1,500
Current Liabilities
$400
Fixed Assets
1,500
Long-Term Debt
600
Common Stock ($1 par value)
400
Retained Earnings
1,600
Total Assets
$3,000
Total Lia. & Equity
$3,000
Exhibit 3
Flight Plan Consulting
Selected Capital Market & Industry Data [1]
Yield on AAA Corporate Debt
6%
Yield on 10-year US-Government Bonds
5.1%
Historical (10-year) return on a broad market average of common stock
16%
Dividend Payout Ratio of a sample of 10 specialized consulting firms
25%
[1] The long-term debt on FPC’s balance sheet carried a coupon rate of 7% and will mature in 5 years. The firm was in the 30% (combined) tax bracket, and had a dividend payout ratio of 30%. The present market price of the firm’s common stock is $18.
Flight Plan Consulting, Inc.
Questions
Describe the company's core business and the market it serves.
What is the compound rate of growth for the firm's sales and net income after-tax?
In view of the firm's operating history, Do Gibson's plans for expansion seem reasonable? Please be specific.
Discuss the role of a corporate board of directors. To whom is the board responsible?
Why are capital market data and information useful when a firm is considering its cost of capital?
What are FPC's historical (book) costs of debt and equity?
What is FPC's historical weighted average cost of capital (WACC)?
Explain the role of the current liabilities in cost of capital calculations.
Should Kay's memo discuss the firm's capital structure? Why, why not?
Is Gibson's desire to provide cost of capital information to members of the board of directors reasonable? Why, why not?
Year
Sales
Net Income After-Tax
EPS
1992
$2,000,000
$240,000
$0.60
1993
2,750,000
338,000
0.84
1994
3,200,000
384,000
0.96
1995
5,000,000
575,000
1.44
1996
5,700,000
600,000
1.50
1997
6,200,000
713,000
1.78
1998
7,300,000
803,000
2.00
1999
8,500,000
860,000
2.15
2000
9,100,000
900,000
2.25
2001
10,300,000
912,720
2.28
Explanation / Answer
Question a) Describe the company's core business and the market it serves.
Flight Plan Consulting, Inc. is a consulting firm engaged in the business of providing very specialized consulting services to companies that have their own planes for purposes of executive transportation. The firm operates in a very niche market segment of Corporate Flights.
Question b) what is the compound rate of growth for the firm's sales and net income after-tax?
The compound annual growth rate (CAGR) is a useful measure of growth over multiple time periods. It can be thought of as the growth rate that gets you from the initial investment value to the ending investment value if you assume that the investment has been compounding over the time period.
The formula for CAGR is:
CAGR = [{(Ending Value/Beginning Value)^(1/No of Periods)} – 1]
Compound rate of growth for the firm’s sales:
CAGR Sale = {(10300000/2000000)^(1/10)} – 1
CAGR Sales = 17.81%
Similarly,
CAGR of Net Income after Tax is:
CAGR Net Income = {(912720/240000)^(1/10)} – 1
CAGR Net Income = 14.29%
Question c) In view of the firm’s operating history, Do Gibson’s plans for expansion seems reasonable? Please be specific.
Yes. The firm’s sales and net income have grown over the years at a CAGR of nearly 18% and 15% respectively. Also looking at the solvency and selected capital market data, the firm has adequate retained earnings and debt to equity ratio for expansion.
SOLVENCY RATIOS
Current Liability to Net Worth Ratio
20%
Long-Term Debt to Net Worth Ratio
30%
Total Liability to Net Worth Ratio
50%
Debt to Total Assets
33%
SELECTED CAPITAL MARKET DATA
INDUSTRY AVERAGE
FPC
Yield on AAA bond
6
7
Yield on 10 year us government bond
5.1
-
Historical 10 year return on a broad market average of common stock
16
13
Dividend payout ratio of a sample of 10 specialised consulting firms
25
30
Question d) Discuss the role of a corporate board of directors. To whom is the board responsible?
A board of directors is a group of people legally charged with the responsibility to govern a corporation. A corporate board is not responsible for the day-to-day decision-making; the daily decisions are made by the corporation's executives and managers.
In a for-profit corporation, the board of directors is responsible to the stockholders - a more progressive perspective is that the board is responsible to the stakeholders, that is, to everyone who is interested and/or can be effected by the corporation. In a non-profit corporation, the board reports to stakeholders, particularly the local communities which the non-profit serves.
Question e) Why are capital market data and information useful when a firm is considering its cost of capital?
The cost of capital is the cost of a firm's debt and equity funds, or the required rate of return on a portfolio of the company's existing securities. It is used to evaluate and decide new projects, as well as the minimum return investors expect from the invested capital.
Capital market data and information are highly useful when a firm is considering its cost of capital. The firm's present rate of earnings is less when the cost of capital is high, which indicates there is more risk and that the capital structure is not balanced. By looking at the capital market data, a firm can minimize its cost of capital and maximize its profit.
Question f) what are FPC's historical (book) costs of debt and equity?
Cost of Debt
Cost of debt is the interest a company pays on its borrowings. It is expressed as a percentage rate. In addition, cost of debt can be calculated as a before-tax rate or an after-tax rate. Because interest is deductible for income taxes, the cost of debt is usually expressed as an after-tax rate.
It has been stated in the case that the long-term debt carried a coupon rate of 7% and the firm is in the tax bracket of 30%. Therefore the after-tax cost of debt is:
= Coupon rate x (1- tax rate)
= 7% x (1 – 30%)
= 4.90 %
Cost of Equity
The cost of equity is the return a company requires to decide if an investment meets capital return requirements. It is often used as a capital budgeting threshold for required rate of return. A firm's cost of equity represents the compensation the market demands in exchange for owning the asset and bearing the risk of ownership. The traditional formulas for cost of equity (COE) are the dividend capitalization model and the capital asset pricing model.
Cost of Equity = [(Dividend per share/Current market value of stock) + growth rate of dividends]
We have been given that the company’s dividend pay-out ratio is 30%, current earnings per share are 2.28 and the current market price of the firm’s common stock is $18. The growth rate of dividend comes out at 32% (= ROE x (1-Dividend Pay out Ratio)
After substituting all values in the above formula we get
Cost of equity = {(2.28 x 30%)/18} + 32
= 0.038 + 32
Cost of equity = 32.038%
SOLVENCY RATIOS
Current Liability to Net Worth Ratio
20%
Long-Term Debt to Net Worth Ratio
30%
Total Liability to Net Worth Ratio
50%
Debt to Total Assets
33%
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