Gamma Airlines has an asset beta of 1.5. The risk-free interest rate is 6%, and the market risk premium is 8%. Assume the capital asset pricing model is correct. Gamma pays taxes at a marginal rate of 35%. Draw a graph plotting Gamma’s cost of equity and after-tax WACC as a function of its debt-to-equity ratio D/E, from no debt to D / E  1.0. Assume that Gamma’s debt is risk-free up to D / E  .25. Then the interest rate increases to 6.5% at D / E  .5, 7% at D / E  .8, and 8% at D / E  1.0. As in Problem 21, you can assume that the firm’s overall beta (  A ) is not affected by its capital structure or the taxes saved because debt interest is tax-deductible.

CHALLENGE AppendixLO1