17-6 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. Jaxair has been around for a few years, and it has about the same basic business risk as Air Tampa would have. Jaxair's market-determined beta is 1.5, and it has a current market value debt ratio (total debt to total assets) of 40% and a federal-plus-state tax rate of 40%. Air Tampa expects to be only marginally profitable at start-up; hence, its tax rate would be only 20%. Air Tampa's owners expect that the total book and market value of t}re firm's stock, if it uses zero debt, would be $12 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 a-n unlevered firm in the commuter airline business based on Jaxair's market-determined beta.

b. Now assume that rd = rf = 10%, and that the market risk premium RPM = 5%. Find the required rate of return on equity for an unlevered commuter airline.

c. Air Tampa is considering three capital structures: (1) $2 million debt, (2) $4 million debt, (3) $6 million debt. Estimate Air Tampa's rs, for these debt levels.

d. Calculate Air Tampa's rs, at $5 million debt while 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 V,, to drop to $9 million.)