A2 Q10

NorthSouth Airlines has been granted permission to fly passengers between major U.S. cities. The new company faces competition from four airlines that operate between the major cities. The betas of the equity of the four major competitors (A, B, C, D) are 2.14, 2.37, 2.81, and 3.17; and the debt-to-equity ratios of these four companies (in the same order: A, B, C, D) are 0.11, 0.28, 0.61, and 0.88. Since the D/E ratios vary, the debt of the airline companies is rated differently with the costs of debt of A, B, C, D being 5.00%, 5.25%, 6.75% and 8.50%, respectively. Suppose the risk-free rate is 3.5% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 5.0%. Assume that the tax rate is 34%, the interest payments on debt are tax deductible and the tax shield on debt is as risky as the assets in the airline business. After some convincing from consultants, the CEO of NorthSouth Airlines decides to adopt the capital structure of comparable Company D for the foreseeable future. An estimate of cost of capital (WACC) of NorthSouth Airlines is: (No more than two decimals in the percentage but do not enter the % sign.)