Giddy | Life Time Fitness

Case study
Life Time Fitness
The Cost of Capital

Prof. Ian Giddy, New York University

The Company
Management at Life Time Fitness, a public company based in Eden Prairie, Minnesota, wanted to know what hurdle rate should be used to evaluate future investments for expansion of the company's network of fitness centers.

As of December 31, 2005, it operated 46 centers, mainly in metropolitan residential areas. The company’s centers offered a selection of amenities and services, such as indoor swimming pools with water slides, basketball, and racquet courts; interactive and entertaining child centers; spas and dining services; and climbing walls and outdoor swimming pools.

Cost of Debt and Equity
At the end of 2005 Life Time's market capitalization was $1,670 million. Its stock had an beta of 0.95 (Reuters estimate) and the company's effective tax rate was 35%. US Treasurys were yielding 5.10% and the long-term market risk premium was about 5.5%. Life Time had recently negotiated a $300 million term loan facility at Libor + 1.25%, although the spread could be as low as 0.75% or as high as 1.75% depending on the company's leverage ratios. With the 10-year swap rate at 5.6%, Life Time's fixed-rate cost of debt was about 6.85%. The company's balance sheet showed the following assets and debt:

In its 2005 Annual Report, the company also reported contractual obligations as follows:

The following is a summary of our contractual obligations as of December 31, 2005:


	Payments due by period
			Less than						More than
	Total		1 year		1-3 years		3-5 years		5 years
					(In thousands)
Long-term debt obligations	$	251,896	$	5,922	$	17,339	$	128,487	$	100,148
Interest (1)		104,372		13,141		22,426		19,418		49,387
Operating lease obligations		141,115		8,643		16,141		15,683		100,648
Capital lease obligations		21,385		8,525		6,416		335		6,109
Purchase obligations (2)		82,694		66,741		15,835		118		—

Total contractual obligations	$	601,462	$	102,972	$	78,157	$	164,041	$	256,292


(1)		Interest expense obligations were calculated holding interest rates constant at December 31, 2005 rates.

(2)		Purchase obligations consist primarily of our contracts with construction subcontractors for the completion of eight of our centers in 2006 and contracts for the purchase of land.

LIFE TIME FITNESS EBITDA

in thousands	2005
Net income	$	41,213
Interest expense, net		14,076
Provision for income taxes		26,758
Depreciation and amortization		38,346

EBITDA	$	120,393

Sources: reuters.com, finance.yahoo.com, Company reports.

Questions

Part 1. What was Life Time's weighted average cost of capital? Would this be an appropriate hurdle rate to use to evaluate expansion projects?

Part 2. What was Life Time's debt/capital ratio? Would if make sense for Life Time to borrow an additional $300 million and use the proceeds to do a share buyback? What effect would this buyback have on the company's cost of capital?