Business and Financial RiskMM 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 1.8, and it has a current market value debt ratio (total debt to total assets) of 45% 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 15%. 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. (These are given in equations V_L = V_U + V_{Tax shield} = V_U + TD, r_sL = r_sU + (r_sU - r_d)(1 - T)(D/S), and b = b_U[1 + (1 - T)(D/S)].)

1. Estimate the beta of an unlevered firm in the commuter airline business based on Jaxair's market-determined beta. (Hint: This is a levered beta; use Equation b = b_U[1 + (1 - T)(D/S)] and solve for b_U.) Do not round intermediate calculations. Round your answer to three decimal places.

2. Now assume that r_d = r_RF = 11% and that the market risk premium RP_M = 7%. 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.

   %

3. Air Tampa is considering three capital structures: (1) $3 million debt, (2) $6 million debt, and (3) $9 million debt. Estimate Air Tampa's r_s for these debt levels. Do not round intermediate calculations. Round your answers to two decimal places.

   1. Air Tampa's r_s for $3 million debt: %

   2. Air Tampa's r_s for $6 million debt: %

   3. Air Tampa's r_s for $9 million debt: %

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