Air Kingston 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 Kingston and smaller surrounding cities. EagleAir has been around for a few years, and it has about the same basic business risk as Air Kingston would have. EagleAir's market-determined beta is 2.0, and it has a current market value debt ratio (total debt/total assets) of 50% and a tax rate of 30%. Air Kingston expects only to be marginally profitable at start-up; hence its tax rate would only be 15%. Air Kingston's owners expect that the total book and market value of the firm's stock, if it uses zero debt, will be $16 million. Air Kingston'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.

a. Estimate the beta of an unlevered firm in the commuter airline business based on EagleAir's market-determined beta.

b. Now assume that r_d = r_RF = 6%, and market preium, PR_M is 5%. Find the required rate of return on equity for an unlevered commuter airline.

c. Air Kingston is considering three capital structures: (1) $2 million debt, (2) $6 million debt, and (3) $8 million debt. Estimate Air Kingston's r_sfor these debt levels.

d. Calculate Air Kingston's r_s at $8 million debt assuming that its tax rate is now 30%. Compare this with your corresponding answer to part c.

12-13. Companies U and L are identical in every respect except that U is unlevered while L has $10 million of 5% bonds outstanding. Assume that (1) all of the MM assumptions are met, (2) there are no corporate or personal taxes, (3) EBIT is $2 million, and (4) the cost of equity to Company U is 10%.

a. What value would MM estimate for each firm?

b. What is r_s for Firm U? For Firm L?

c. Find S_L and then show that S_L + D = V_L = $20 million

d. What is the WACC for Firm U? For Firm L?

e. Suppose V_U = $20 million and V_L = $22 million. According to MM, do these values represent an equilibrium? If not, explain the process by which equilibrium would be restored.