Air Tampa is going to commence its business as a cheap flight provider. The firm needs to raise $1 million to purchase its fixed assets and expects to earn a 15% return on these assets. Due to the preferential tax policy, Air Tampa will not pay any tax. However, the CEO is concerned with how to raise the required capital. It is assumed that the capitalization rate for an all-equity firm in the airline industry is 10%. In addition, Air Tampa can obtain the loan by 5%.

Required:

(a) If the MM theory holds valid, calculate the value of Air Tampa without any debt financing. What is your answer if Air Tampa borrows $0.5 million of 5% debt? (1 mark)

(b) If Air Tampa is all-equity financed, evaluate its return on equity and weighted average cost of capital, respectively. How about your answer if the debt level changes to $1 million? In light of the calculation, discuss the impact of leverage on firm value. (2.5 marks)

(c) Now it is assumed that Air Tampa needs to pay the corporate income tax of 30%, assess the firm value for Air Tampa with zero debt and with $0.5 million debt. (2 marks)

(d) Evaluate the maximal debt that Air Tampa is allowed to borrow. What is the firm value and cost of debt in this circumstance? (1.5 marks)