Business and Financial Risk$-$MM Model

Air Tampa has just been incorporated, and its board of directors is grappling with the question of optimal capital structure. The company plans to offer commuter air services

between Tampa and smaller surrounding cities. Air Tampa believes it would have the same business risk as Jaxair, which is an airline that has been around for a few years and

that has had zero growth. Jaxair's market$-$determined beta is $2\mathrm{.}4,$ and it has a current market value debt ratio $($total debt to total assets$)$ of $55\%$ and a federal$-$plus$-$state tax

rate of $25\%.$ Air Tampa expects to have investment tax credits when it begins business, which reduces its federal$-$plus$-$state tax rate to $20\%.$ Air Tampa's owners expect that

the total book and market value of the firm's stock, if it uses zero debt, would be $$9$ 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 because zero growth is expected.

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.

b$.$ Now assume that $r_d=r_{RF}=8\%$ and that the market risk premium $RP{M}_M=5\%.$ 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.

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c$.$ Air Tampa is considering three capital structures: $(1)$ $$2$ million debt, $(2)$ $$4$ million debt, and $(3)$ $$6$ million debt. Estimate Air Tampa's $r_s$ for these debt levels. Do not round

intermediate calculations. Round your answers to two decimal places.

Air Tampa's $r_s$ for $$2$ million debt:

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Air Tampa's $r_s$ for $$4$ million debt:

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Air Tampa's $r_s$ for $$6$ million debt:

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d$.$ Suppose Air Tampa's investment tax credits expire, causing it to have a $25\%$ federal$-$plus$-$state tax rate. Calculate Air Tampa's $r_S$ at $$6$ million debt using the new tax rate.

$($Hint: The increase in the tax rate causes Vu to drop to $$8\mathrm{.}4375$ million.$)$ Do not round intermediate calculations. Round your answer to two decimal places.

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Compare this with your corresponding answer to Part c$.($Assume that growth is zero and no personal taxes for the MM$.)$

The levered beta will

if EBIT remains constant.