MM model Air Tampa has just been incorporated, and its board of directors is currently grappling with the question of optimal capital structure. The company plans to offer commuter air services between Tampa and smaller surrounding cities. Jaxair has been around for a few years, and it has about the same basic business risk as Air Tampa would have. Jaxair's market-determined beta is 1.7, and it has a current market value debt ratio (total debt to total assets) of 50% and a federal-plus-state tax rate of 35%. Air Tampa expects to be only marginally profitable at start-up; hence its tax rate would only be 30%. Air Tampa's owners expect that the total book and market value of the firm's stock if it uses zero debt, would be $14 million.
Air Tampa's CFO believes that the MM and Hamada formulas for the value of a levered firm and the levered firm's cost of capital should be used.
These are given in equations
VL=VU+VTaxshield=VU+TD, rsL=rsU+(rsU−rd)(1−T)(D/S),.)and, b=bU[1+(1−T)(D/S)]
A) Estimate the beta of an unlevered firm in the commuter airline business based on Jaxair's market-determined beta. Do not round intermediate calculations. Round your answer to three decimal places.
(Hint: This is a levered beta; use Equation b=bU[1+(1−T)(D/S)] and solve for bU.)
B) Now assume that rd = rRF = 11% and that the market risk premium RPM = 7%. Find the required rate of return on equity for an unlevered commuter airline. Do not round intermediate calculations. Round your answer to three decimal places.
C) Air Tampa is considering three capital structures: (1) $1 million debt, (2) $5 million debt, and (3) $7 million debt. Estimate Air Tampa's rs for these debt levels. Do not round intermediate calculations. Round your answers to two decimal places. Air Tampa's rs for $1 million debt is % Air Tampa's rs for $5 million debt is % Air Tampa's rs for $7 million debt is %
D) Calculate Air Tampa's rs at $7 million debt while assuming its federal-plus-state tax rate is now 40%. Do not round intermediate calculations. Round your answer to two decimal places. (Hint: The increase in the tax rate causes VU to drop to $12 million.)