Problem 2104 Business and Financial RiskMM Model Air Tampa h

Problem 21-04
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 1.6, 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 30%. Air Tampa\'s owners expect that the total book and market value of the firm\'s stock, if it uses zero debt, would be $14 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. (These are given in equations VL = VU + VTax shield = VU+ TD, rsL = rsU + (rsU - rd)(1 - T)(D/S), and b = bU[1 + (1 - T)(D/S)].)

Estimate the beta of an unlevered firm in the commuter airline business based on Jaxair\'s market-determined beta. (Hint: This is a levered beta; use Equation b = bU[1 + (1 - T)(D/S)] and solve for bU.) Do not round intermediate calculations. Round your answer to three decimal places.

Now assume that rd = rRF = 9% and that the market risk premium RPM = 7%. 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.
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Air Tampa is considering three capital structures: (1) $3 million debt, (2) $5 million debt, and (3) $7 million debt. Estimate Air Tampa\'s rs for these debt levels. Do not round intermediate calculations. Round your answers to two decimal places.

Air Tampa\'s rs for $3 million debt is  %.

Air Tampa\'s rs for $5 million debt is  %.

Air Tampa\'s rs for $7 million debt is  %.

Calculate Air Tampa\'s rs at $7 million debt while assuming its federal-plus-state tax rate is now 40%. (Hint: The increase in the tax rate causes VU to drop to $12 million.) Do not round intermediate calculations. Round your answer to two decimal places.
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Compare this with your corresponding answer to part c.
Higher tax rate -Select-keeps the sameincreasesreducesItem 7 the financial risk premium at a given market value debt/equity ratio.

Solution

Greetings,

1) Beta for a firm can be calculated by delevering the beta of comparable firm and then re-levering with its own debt equity ratio.

Beta (levered) = beta (unleveled) * [1+ debt/equity * (1- tax rate)?

1.6 = bu * [1+45/55*0.6]

Bu = 1.0731

BL = 1.0731*?1+0*0.70? = 1.0731*

*Air Tampa has zero debt.

2) Rf = 9% MRP = 7% Beta = 1.0731

Therefore as per CAPM ;

Re = RF + Beta* MRP = 9+1.0731*7 = 16.51%

3) Value of all equity financed firm = 14 million . It\'s rs = 16.51%

There is no growth , hence its NOI = Value * rs = 14m * 16.51% = 2.311m

Case -1 3m debt, hence 11m equity

Value of the levered firm = 14m + 3m*0.3 = 14.9m

NOI = 2.311m

Rs = NOI/Value * 100 = 2.311/14.90 *100 = 15.5143%

Case 2 - 5m debt and 9m equity

value of the levered firm = 14m + 5m * 0.3 = 15.5m

Rs = 2.311/15.5 * 100 = 14.9138%

Case 3 - Debt and equity both 7m

value of the levered firm = 14m + 7m*0.3 = 16.1m

Rs = 2.311/16.1*100 = 14.358%

4) If tax rate increases to 40% now then -

VU = 12m

VL = 12 m + 7m* (1-0.4) = 16.2m

NOI = 2.311 (assumed to be the same)*

Therefore, rs = 2.311/16.20* 100 = 14.340%

* Ideally NOI will fall due to increase in tax rate as under -

Old NOI after tax = 2.311m

Old NOI before tax = 2.311/0.70= 3.30234m

New NOI after tax = 3.30234*0.60 = 1.9814m

Rs = 1.9814/16.20*100 = 12.23%

Compared to part c above, value of the firm has risen by 0.1m therefore rs has fallen marginally from 14.36% to 14.34%