P15.10 Cost of Capital. Eureka Membership Warehouse, Inc., is a rapidly growing chain of retail…

P15.10 Cost of Capital. Eureka Membership Warehouse, Inc., is a rapidly growing chain of retail outlets offering brand-name merchandise at discount prices. Asecurity analyst’s report issued by a national brokerage firm indicates that debt yielding 13% composes 25% of Eureka’s overall capital structure. Furthermore, both earnings and dividends are expected to grow at a rate of 15% per year.

Currently, common stock in the company is priced at $30, and it should pay $1.50 per share in dividends during the coming year. This yield compares favorably with the 8% return currently available on risk-free securities and the 14% average for all common stocks, given the company’s estimated beta of 2.

A.   Calculate Eureka’s component cost of equity using both the capital asset pricing model and the dividend yield plus expected growth model.

B.    Assuming a 40% marginal federal-plus-state income tax rate, calculate Eureka’s weighted- average cost of capital.

 

 

 

 

 

 

  CASE STUDY Investment Project Analysis at FlightSafety International,    Inc.

FlightSafety International, Inc., trains more than 30,000 corporate, commercial, and military pilots per year and has found its niche business to be enormously profitable. Net profit margins have averaged roughly 30% of sales during the 1980s and mid-1990s. It is the only company to have earned a spot on Forbes’ annual list of the best up-and-comers in every year during this peri- od. Over this period, FlightSafety’s profits rose more than fivefold, and the company racked up an average rate of return on common equity of 18% to 20% per year. Its stock was up from $7 a share (split-adjusted) in 1982 to more than $50 in 1996, at which point FlightSafety was purchased by Berkshire Hathaway, Inc., in a cash and stock transaction worth $1.5 billion. Among the 9,500 stockholders that benefited from the company’s amazing success is company founder, chairman, and president Albert Ueltschi and his family, who owned roughly one-third of FlightSafety com- mon stock prior to the Berkshire buyout.

What separates FlightSafety from other small companies that look good for a couple of years and then crash and burn is the quality of top management. Ueltschi is widely regarded as dedicated, highly intelligent, and honest. He started FlightSafety in 1951, while working as a pilot for Pan American Airways. Since 1946 he had served as the personal pilot to Pan Am’s colorful founder, Juan Trippe, flying Trippe around in a converted B-23 military transport. During the early years of this association, Ueltschi noticed that other corporate CEOs were buying surplus military planes and converting them into corporate aircraft. He also noticed that many of the former military pilots who were signing on as corporate pilots had little or no training on the specific planes they were being hired to fly. Ueltschi reasoned that corporations would pay to rectify this dangerous situation.

Ueltschi opened an office next to Pan Am’s LaGuardia terminal and began hiring moon- lighting pilots from Pan Am and United to train corporate pilots. Actual flight instruction was done in the clients’ aircraft. Additional instrument training was done on instrument trainers, rented by the hour from United Airlines. Early clients included Kodak, Burlington Industries, and National Distillers. Ueltschi poured all the profits back into the business, a practice he still abides by. During the past decade, the company has spent ever-increasing amounts on new plant and equipment; current capital expenditures total roughly $100 million per year.

Today FlightSafety is the largest independent flight trainer in the United States. So complete is its grip on the market that 20 aircraft manufacturers, among them Gulfstream, Cessna, and Learjet, include its training with the price of a new plane. The company trains pilots on sophis- ticated flight simulators at training centers located adjacent to manufacturers’ plants, military bases, and commercial airports. Flight simulators not only recreate the look, feel, and sound of flying specific planes but also simulate emergency flight conditions—such as wind shear or the loss of a hydraulic system—that one does not want to attempt with an actual plane. Training on a simulator is also significantly cheaper than training in an actual plane. FlightSafety’s simulator time for a Boeing 737, for example, costs about $550 an hour. Operating costs for an actual 737 are about $3,000 an hour. The company, which now builds most of its own simulators at a cost of $8 million to $12 million each, is putting new ones into service at a rate of three per quarter.

To illustrate the company’s capital budgeting process, assume that FlightSafety had built a given simulator for $8 million 2 years ago. The company uses straight-line depreciation over the simulator’s projected 12-year life. Therefore, the used flight simulator has a present depre- ciated book value of $6.5 million; it has a current market value of $7.5 million (before taxes). If kept, the used simulator will last 10 more years and produce an expected net cash flow before tax (CFBT) of $2.5 million per year. Anew flight simulator costs $12 million to build but has greater capabilities and is expected to generate CFBT of $4 million per year over a useful life of 15 years. Assume that neither the new nor the used flight simulator has any salvage  value