Business and Financial Risk - MM Model
Air Tampa 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 Tampa and smaller surrounding cities. Jaxair has been around for a few years, and it has about the same business risk as Air Tampa would have. Jaxair's market- determined beta is 1.8, and it has a current market value debt ratio (total debt/total assets) of 50% and a federal-plus-state tax rate of 40%. Air Tampa expects only to be marginally profitable at start-up; hence its tax rate would only be 25%. Air Tampa's owners expect that the total book and market value of the firm's stock, if it uses zero debt, would be $10 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.
a) Estimate the beta of an unlevered firm in the commuter airline business based on Jaxair's market-determined beta. (Hint: Jaxair's market-determined beta is a leveraged beta. Use Equation: b = bU[1 + (1 - T) (D/S)], then solve for bU ).
b) Now assume that rd = rRF = 10% and the market risk premium, RPM, is 5 percent. Find the required rate of return on equity for an unlevered commuter airline.
c) Air Tampa is considering three capital structures: (1) $2 million dollar debt, (2) $4 million dollar debt, and (3) $6 million dollar debt. Estimate Air Tampa's rs for these debt levels.
d) Calculate Air Tampa's rs at $6 million debt assuming its federal-plus-state tax rate is now 40%. Compare this with your corresponding answer to part c. (Hint: The increase in the tax rate causes VU to drop to $8 million.)
a) bL = bU[1 + (1 - T) (D/S)]
bU = bL / [1 + (1 - T) (D/S)]
= 1.8/ [1 + (1 - 0.40) (0.5/0.5)] = 1.125
b) rsU = rRF + bU(RPM)
= 10% + 1.125(5%) = 15.625%
c) at $2 million debt
VL = VU + TD VL = D + S => 10.5 = 2 + S
= 10 mill. + (2 mill x 0.25) = 10.5 mill. S = 8.5
rsL = rRF + bU(RPM) + bU(RPM)(1 ...
This solution is comprised of a detailed explanation to compute the required rate of return on equity for an unlevered commuter airline.