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...

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 2.1, and it has
a current market value debt ratio (total debt to total assets) of 50% and a federal-plusstate 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 $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
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.
b. Now assume that r_d
= r_RF
= 10% and that the market risk premium RP_M
= 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, and (3) $6 million debt. Estimate Air Tampa’s r_s
for these debt levels.
d. Suppose Air Tampa’s investment tax credits expire, causing it to have a 25% federalplus- state tax rate. Calculate Air Tampa’s r_s
at $6 million debt using the new tax rate.
Compare this with your corresponding answer to Part c. (Hint: The increase in the tax rate causes V_U
to drop to $9.375 million.)