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 firms balance sheet, specifically the capital structure, the yield on the firms debt, and the rate of return on the firms 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

($000s)

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 FPCs 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 firms 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?