(Hint: The question is not 100% clearly about how the required rate of return on debt will change with debt-equity ratio. Therefore T8_Q4_question.xlsx is attached to provide you sufficient information. Filling in the missing entries of this table and plotting the cost of assets, debt, equity and after-tax WACC will give you a good review for this topic. )
Gamma Airlines has an asset beta of 1.5. The risk-free interest rate is 6%, and the market risk premium is 8%. Assume the capital asset pricing model is correct. Gamma pays taxes at a marginal rate of 35%. Draw a graph plotting Gamma's cost of equity and after-tax WACC as a function of its debt-to-equity ratio D/E, from no debt to D/E = 1.0. Assume that Gamma's debt is risk-free up to D/E = .25. Then the interest rate increases to 6.5% at D/E = .5, 7% at D/E = .8, and 8% at D/E = 1.0. As in Problem 21, you can assume that the firm's overall beta (BA) is not affected by its capital structure or the taxes saved because debt interest is tax-deductible. DV WACC D/E 0.000 0.050 0.100 0.150 0.200 0.250 0.300 0.350 0.400 0.450 0.500 0.550 0.600 0.650 0.700 0.750 0.800 0.850 0.900 0.950 1.000 Return (%) D 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.0600 0.0600 0.0600 0.0600 0.0600 0.0600 0.0610 0.0620 0.0630 0.0640 0.0650 0.0660 0.0670 0.0680 0.0690 0.0705 0.0720 0.0735 0.0750 0.0775 0.0800 0.8 02 0.4 0.6 Debt-Equity Ratio (D/E) Debe Equity Ratio (D/E) Gamma Airlines has an asset beta of 1.5. The risk-free interest rate is 6%, and the market risk premium is 8%. Assume the capital asset pricing model is correct. Gamma pays taxes at a marginal rate of 35%. Draw a graph plotting Gamma's cost of equity and after-tax WACC as a function of its debt-to-equity ratio D/E, from no debt to D/E = 1.0. Assume that Gamma's debt is risk-free up to D/E = .25. Then the interest rate increases to 6.5% at D/E = .5, 7% at D/E = .8, and 8% at D/E = 1.0. As in Problem 21, you can assume that the firm's overall beta (BA) is not affected by its capital structure or the taxes saved because debt interest is tax-deductible. DV WACC D/E 0.000 0.050 0.100 0.150 0.200 0.250 0.300 0.350 0.400 0.450 0.500 0.550 0.600 0.650 0.700 0.750 0.800 0.850 0.900 0.950 1.000 Return (%) D 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.35 0.0600 0.0600 0.0600 0.0600 0.0600 0.0600 0.0610 0.0620 0.0630 0.0640 0.0650 0.0660 0.0670 0.0680 0.0690 0.0705 0.0720 0.0735 0.0750 0.0775 0.0800 0.8 02 0.4 0.6 Debt-Equity Ratio (D/E) Debe Equity Ratio (D/E)
