Business and Financial Risk-MM Model Air Tampa has just been incorporated, and i
ID: 2782408 • Letter: B
Question
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 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 45% 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 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 $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. (These are given in equations VL-Vu+VTax shield-VuTD, rsL-su+(su-ra1 T)(D/S), and b bul1 (1 T)(/) a. Estimate the beta of an unlevered firm in the commuter airline business based on Jaxair's market-determined beta. Do not round intermediate calculations. Round your answer to three decimal places. (Hint: This is a levered beta; use Equation b-bu[1 (1 T)(D/S)] and solve for bu.) b. Now assume that rd-TRF-11% and that the market risk premium RPM 4%. 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. c.Air Tampa is considering three capital structures: (1) $2 million debt, (2) $4 million debt, and (3) $lion debt. Estimate Air Tampa's rs for these debt levels. Do not round intermediate calculations. Round your answers to two decimal places. 1. Air Tampa's rs for $2 million debt is 2. Air Tampa's r: for $4 million debt is 3. Air Tampa's rs for $6 million debt is d. Calculate Ar Tampas r; at $6 million debt while assuming its federal plus-state tax rate is no 40% o not round inter mediate ca ulations. Round your answer to decimal pla es -nt The ncrease n he a rate causes Vu to drop to $7 million.) Compare this with your corresponding answer to part c. Higher tax rate -Select- the financial risk premium at a given market value debt/equity ratio.Explanation / Answer
Answer a. Jaxair's market determined beta i.e. B=1.5 and tax ie. T = 40%
Also debt ratio = total debt / total asset = 45% thus equity = 1-0.45=0.55=55%
Debt to equity ratio i.e. (Debt/Equity) would be 45/55 = 0.8181
beta of unlevered firm ie. unlevered commuter airline= beta / 1+(1-T)*(Debt/Equity)
= 1.5 / 1+(1-0.4)*(0.8181)
= 1.5 / 1+(0.49086)
=1.5/1.491
=1.006
Answer b. Here rf=11%, Market risk preium = 4% and beta of unlevered commuter airlines = 1.006
Required return on equity using CAPM model = rf+Beta(Market risk premium)
=0.11+1.006(0.04)
=0.11+0.04024
=0.15024
=15.024%
Answer c. To find rs i.e. cost of equity uing different debt capital structures we need to relever beta for each of the three scenarios and use its beta for calculating cost of equity.
Given Air Tampa Equity = 9 million and tax rate = 25%, unlevered beta = 1.006
Re-levered beta = unlevered beta*(1+(1-T)*(Debt/Equity))
(1) here debt is 2 million
Re-levered beta = unlevered beta*(1+(1-T)*(Debt/Equity))
=1.006*(1+(1-0.25)*(2/9))
=1.006*(1+(0.75)*(0.223))
=1.006*(1+0.1667)
=1.006*1.1667
=1.174
and thus Cost of equity i.e rs= rf+Beta(Market risk premium)
=0.11+1.174(0.04)
=0.11+0.04696
=0.15696
=15.696%
(2) debt of 4 million
Re-levered beta = unlevered beta*(1+(1-T)*(Debt/Equity))
=1.006*(1+(1-0.25)*(4/9))
=1.006*(1+(0.75)*(0.445))
=1.006*(1+0.334)
=1.006*1.334
=1.341
and thus Cost of equity i.e rs= rf+Beta(Market risk premium)
=0.11+1.341(0.04)
=0.11+0.05364
=0.16364
=16.364%
(3) here debt is 6 million
Re-levered beta = unlevered beta*(1+(1-T)*(Debt/Equity))
=1.006*(1+(1-0.25)*(6/9))
=1.006*(1+(0.75)*(0.667))
=1.006*(1+0.5)
=1.006*1.5
=1.509
and thus Cost of equity i.e rs= rf+Beta(Market risk premium)
=0.11+1.509(0.04)
=0.11+0.06036
=0.17036
=17.036%
Answer d. assuming 6 million debt and 40% tax rate, cost of equity will be
(1) here debt is 6 million
Re-levered beta = unlevered beta*(1+(1-T)*(Debt/Equity))
=1.006*(1+(1-0.4)*(6/9))
=1.006*(1+(0.6)*(0.667))
=1.006*(1+0.4)
=1.006*1.4
=1.4084
and thus Cost of equity i.e rs= rf+Beta(Market risk premium)
=0.11+1.4084(0.04)
=0.11+0.056336
=0.166336
=16.634%
Thus to conclude:
Higher tax rate reduces the financial risk premium at a given market value debt/equity ratio
because,
higher tax rate helps earn higher interest tax shield for the debt raised.
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