Chapter 17, Problem 22PS

After-tax WACC Gamma Airlines has an asset beta of L.5. The risk-free interest rate is 6%, and the market risk premium is 8%. Assume the capital asset pricing model is correct. Gamma pays taxes at a marginal rate of 25%. Draw a graph plotting Gamma's cost of equity and after-tax WACC as a function of its debt-to-equity ratio DIE, from no debt to DIE= 1.0. Assume that Gamma’s debt is risk-free up to DIE= .25. Then the interest rate increases to 6.5% at DIE= .5, 7% at DIE= .8, and 8% at DIE= 1.0. As in Problem 21, you can assume that the firm's overall beta (β_A) is not affected by its capital structure or the taxes saved because debt interest is tax-deductible.