Question

Flight Plan Consulting, Inc.

Cost of Capital and Firm Valuation Project

The Company background

Bill Gibson began Flight Plan Consulting, Inc. (FPC) in 1990. The company offered very specialized consulting services to corporate flight departments, i.e., to those companies that have their own planes for purposes of executive transportation. This consultancy focused on the cost versus benefit considerations of the acquisition and use of corporate aircraft. Bill Gibson was ideally suited for this line of work; 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 $5 million, and the employee headcount was up to ten. In the twelve years since the company's inception, sales, earnings and the company's fine reputation have increased steadily. The company's financial information, and selected capital market and industry data and information are provided in Table 1.

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. This 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, share the ownership of a corporate aircraft. For example, a company that wishes to buy fractional ownership will buy or lease a 1/5 interest in an airplane. Such an arrangement would allow for approximately 160 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, 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. [1]

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 are 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 use 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 immediately to acquire clients in Canada or 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.

Cost of Capital

Gibson believed that long-term capital from external sources would be needed to finance the acquisition. He 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.

Although the company’s board of directors was made up of successful and knowledgeable people from a variety of backgrounds, not all of them were intimately familiar with finance; it was, therefore, essential to answer any questions they had with authority. The firm’s investment in any asset, including other companies, was a result of the strategic plan, which the board had helped to develop and had certainly approved. The cost of capital issue was a very necessary tool in the implementation of that plan. The economic worth of any investment made by FPC would be measured against the firm’s cost of money, its opportunity cost, its cost of capital; terms that Gibson knew were interchangeable. At this crucial stage of the company’s development, he wanted his board to be “conversational” with those terms.

Gibson decided that he had better provide some specific and detailed information to his board concerning the company's cost of capital and its relation to the valuation process. In order to move the process along, Gibson decided to hand over the task of preparing a draft of “Cost of Capital and Acquisition Plans Memo”, as it had come to be called, to Kay Biddle. Biddle was a summer intern employed in FPC's controller's office. She was an MBA student and planned to graduate at the end of the fall semester with a concentration in finance. To construct her memo Biddle wondered how she, in relatively few words, could best show the interrelationship among the firm’s 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.

Acquisition Plans

The board, Gibson believed, also needed to consider the effect of the impending acquisition upon the firm’s sales and net income after-tax. The purpose of the acquisition is to increase sales and income and to diversify the firm in terms of its geographic market. That is a key element in the long-term success of specialized consulting firms in FPC’s line of business.

FPC identified two possible target companies to acquire:

Maple Aviation, a fast-growing company with clients in major Canadian cities, such as Vancouver, Toronto, and Montreal.

Das Flugzeug, an established consulting company providing services to clients in Berlin, Frankfurt, and Munich.

Gibson asked Biddle to calculate the firm values of the above-mentioned targets and include the details in the memorandum. FPC's financial staff had spent considerable time analyzing the target companies’ current and historical financial statements. The analysis helped to determine the level of free cash flows after possible acquisition. The future expected free cash flows are the net cash flows available to the firm's investors after all investment in fixed assets and working capital have been made. The expected free cash flows from Maple Aviation and Das Flugzeug are listed in Table 2 and Table 3, respectively. All values are in US dollars. The last step of firm value calculation is to discount the cash flows at the weighted average cost of capital. The valuation process would help FPC justify the fair costs to acquire the target companies.

Table 1: Selected Firm, Industry, and Capital Market Data

FPC, Inc. issued 10-year $1,000-par bonds five years ago. They carried a coupon rate of 6%. The coupons were paid annually. Currently the bond is selling for $883.40. The firm’s stock price has risen to $21.50 recently. It was $10 when issued. The firm’s return on equity (ROE) is 20%, and its dividend payout ratio is 40%. It just paid $1 annual dividend recently. The dividend is expected to grow at a constant rate. Assume the firm is in the 30% (combined) tax bracket. Many specialized consulting firms have a long-term debt to total asset ratio of approximately 40 percent on average. It is considered to be the optimal debt to value ratio.

Table 2: Free Cash Flows (Thousands of US Dollars) of Maple Aviation

Year	1	2	3	4 and thereafter
Free Cash Flows ('000s of US$)	320.00	400.00	480.00	Grow at a constant rate of 6%

Table 3: Free Cash Flows (Thousands of Euros) of Das Flugzeug

Year	1	2	3 and thereafter
Free Cash Flow ('000s of US$)	550.00	720.00	910.00 each year indefinitely

Your task:

Suppose you are Kay Biddle and you will prepare the memorandum. You have to structure your memorandum around the following items:

Describe the company's core business and the market it serves.

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?

Calculate and present FPC's weighted average cost of capital.

Calculate and present the valuation of the two target companies to acquire.

Quantitatively discuss the comparison of the two targets.

In general, describe the effect upon the cost of capital of changes in capital market conditions such as an increase in interest rates, or a decline in stock prices.

Discuss how various factors may affect the cash flow estimates and FPC's project evaluation.

Note:

The format of the report is memorandum addressing to the board of directors. The body of your memorandum must not exceed 6 single-sided letter-size pages of typed 12-point-font double-spaced characters. You may include tables and figures in an appendix and reference them in the body of the report. If you make any assumptions or use information from external sources, state or cite them clearly. Writing and analysis should be performed by each student individually.

[1] The other options are, for less than 100 hours per year, use a charter service; for usage over 350 hours per year, operate an in-house flight department.

Answer 1

Memorandum
To: Chief Executive Officer
FROM: Kay Biddle
CC: Board of Directors
DATE: [put todays date]
SUBJECT: COST OF CAPITAL AND INTERNATIONAL FIRM VALUATION
The core business of the company is the provision of specialized consulting services to the corporate flight departments. These companies have their own planes for executive transportation activities. The company serves the corporate flight departments around the United States. The company has also reach the international markets like those of Canada and parts of Western Europe.
The corporate board of directors have a number of roles in the running of a business firm. The board of directors have the responsibility of establishing vision, mission and values of the company. The board also set strategy and structure that the organization should adapt. The board also exercise accountability to shareholders. They ensure that the communication between the management and the shareholders is very effective. The board must also be responsible to the company shareholders. They also delegate the management authority to the workers of the organization.
Capital market data and information are very useful when calculation the cost of capital. This is because the information in the capital market data are needed in the calculation of the market interest rate for debt capital. The market cost of equity capital is also much needed by the companies which want to calculate the cost of capital. The market share price information is also needed when calculating the cost of capital. These information are retrieved from capital market data and information.
Marginal cost of capital refers to the weighted average cost of the last dollar of capital raised. This measure is used by the company when making the best composition of the capital structure to be used in the business firm. As more capital is used or raised, the value of marginal cost of capital rises. The marginal cost of capital is the breakpoints in which the cost of raising capital from a different source after one source is depleted. The historical costs may not be much necessary in calculating the new capital, they provide a good history of the cost of capital that a company has been using. Marginal costs of capital are useful in raising and investing new capital.
Changes in capital market conditions such as increase in interest rates or a decline in the stock prices affect the cost of capital. The cost of capital for example equity will increase when the stock price falls. When calculating the cost of equity, the denominator is the stock price, reducing the denominator will result in an increase in the cost of capital keeping the dividends constant. When the prices of stock rises the cost of equity will be cheaper. When market interest rate increases, the cost of debt capital will increase. When market interest rates falls the cost of debt capital will reduce too.
The weighted cost of Flight Plan Consulting is calculated as follows,
WACC= we*ke+ Wd*Kd
We= 60% and Wd= 40%
Kd= 6 %( 1-0.3) = 4.2%
Ke= 1/ (21.50-21.50*20%) = 5.81%
WACC= 0.4*5.81%+ 0.6*4.2%= 2.324%+ 2.52%= 4.844%
WACC= 4.844%  
The marginal cost of capital of Flight Plan consulting should always be least costly combination of the cost of debt and cost of equity capital. The firm should always be at the level where raising new capital is not very costly to the company.