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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-plus-state 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 rd = rRF = 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, and (3) $6 million debt. Estimate Air Tampa’s rs for these debt levels.
- d. Suppose Air Tampa’s investment tax credits expire, causing it to have a 25% federal-plus-state tax rate. Calculate Air Tampa’s rs 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 VU to drop to $9.375 million.)
a.
To calculate: Beta of unlevered firm.
Introduction: Beta represents riskiness of a company’s shares in relation with market. It is used to determine the value of the company’s shares.
Explanation of Solution
Given information:
Beta of the company (Bl): 2.1
Tax rate: 25%
Expected tax rate: 20%
Debt to total asset ratio: 50%
Company’s book value (unlevered): $10 million
Formula to calculate beta of unlevered firm:
Substitute 2.1 for Bl, 0.25 for tax rate, 0.5 for weight of debt, and 0.5 for weight of equity in the above formula.
Therefore, value of unlevered beta (Bu) is 1.2.
b.
To calculate: Required return on equity for unlevered company.
Introduction: Rate at which investors expect return from the investments made in the shares of the company is referred as expected rate of return.
Explanation of Solution
Given information:
Beta of the unlevered company (Bu): 1.2
Risk free rate (Rrf): 10%
Market risk premium (Rpm): 5%
Formula to calculate required return on equity for unlevered company:
Substitute 10% for Rrf, 5% for Rpm, and 1.2 for Bu, in the above formula.
Therefore, required return on equity for unlevered company is 16%.
c.
(1)
To calculate: Cost of equity levered.
Introduction: Levered Company refers that the company has debt component in its capital structure in addition to equity. Cost of equity when a company has debt component is referred as levered cost of equity.
Explanation of Solution
Given information:
Debt (D): $2 million
Risk free rate (Rrf): 10%
Expected tax rate: 20%
Company’s book value (unlevered) (Vu): $10 million
Cost of equity unlevered (Rsu): 16%
Formula to calculate cost of equity levered:
Substitute 16% for Rsu, 10% for Rrf, 20% for tax rate, $2 million for debt, and $10.4 million for total value in the above formula.
Working Notes:
1.
Calculate company’s book value levered:
(2)
To calculate: Cost of equity levered.
Introduction: Levered Company refers that the company has debt component in its capital structure in addition to equity. Cost of equity when a company has debt component is referred as levered cost of equity.
Explanation of Solution
Given information:
Debt (D): $4 million
Risk free rate (Rrf): 10%
Expected tax rate: 20%
Company’s book value (unlevered) (Vu): $10 million
Cost of equity unlevered (Rsu): 16%
Formula to calculate cost of equity levered:
Substitute 16% for Rsu, 10% for Rrf, 20% for tax rate, $4 million for debt, and $10.8 million for total value in the above formula.
Working Notes:
1.
Calculate company’s book value levered:
(3)
To calculate: Cost of equity levered.
Introduction: Levered Company refers that the company has debt component in its capital structure in addition to equity. Cost of equity when a company has debt component is referred as levered cost of equity.
Explanation of Solution
Given information:
Debt (D): $6 million
Expected tax rate: 20%
Risk free rate (Rrf): 10%
Company’s book value (unlevered) (Vu): $10 million
Cost of equity unlevered (Rsu): 16%
Formula to calculate cost of equity levered:
Substitute 16% for Rsu, 10% for Rrf, 20% for tax rate, $6 million for debt, and $11.2 million for total value in the above formula.
Working Notes:
1.
Calculate company’s book value levered:
d.
To calculate: Cost of equity levered.
Introduction: Levered Company refers that the company has debt component in its capital structure in addition to equity. Cost of equity when a company has debt component is referred as levered cost of equity.
Explanation of Solution
Given information:
Debt (D): $6 million
Risk free rate (Rrf): 10%
Expected tax rate (T): 25%
Company’s book value (unlevered) (Vu): $9.375 million
Cost of equity unlevered (Rsu): 16%
Formula to calculate cost of equity levered:
Substitute 16% for Rsu, 10% for Rrf, 25% for tax rate, $6 million for debt, and $10.875 million for total value in the above formula.
Working Notes:
1.
Calculate company’s book value levered:
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Chapter 21 Solutions
FINANCIAL MANAGEMENT: THEORY AND PRACTIC
- Globex Corp. is an all-equity firm, and it has a beta of 1. It is considering changing its capital structure to 60% equity and 40% debt. The firm's cost of debt will be 6%, and it will face a tax rate of 25%. What will Globex Corp.'s beta be if it decides to make this change in its capital structure? Now consider the case of another company: US Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its curre is 25%. It currently has a levered beta of 1.15. The risk-free rate is 3.5%, and the risk 1.65 1.58 1.80 1.50 e-tax cost of debt is 6%, and its tax rate m on the market is 7.5%. US Roboticsarrow_forwardHerbo is a pharmaceutical company that is eyeing expansion. The entire decision on expansion is dependant on the accurate estimation of WACC. Using the supporting numbers/information below find Herbos; WACC, Cost of Equity, Cost of debt. -The Initial cost of expansion is around 6.5 million. which would cover capex and working capital. Projected cash flows are below. Sales are expected to grow by 15% for the first five years and 10% for another five. Beyond the forecasted period there is an assumed perpetual growth rate of 5%. The project was planned to be financed by 80% equity and 20% debt. At this time Herbo had almost no debt - To find WACC you need to estimate the cost of debt and equity. To find WACC you will need Beta. As Herbo is an unlisted company you can estimate the beta based on comparable firms numbers found in the numbers below. - The most viable source of debt financing for Herbo was bank loans. The RBI has set the latest lending rate at 8.58 per cent. Herbo can also…arrow_forwardHerbo is a pharmaceutical company that is eyeing expansion. The entire decision on expansion is dependant on the accurate estimation of WACC. Using the supporting numbers/information below find Herbos; WACC, Cost of Equity, Cost of debt. -The Initial cost of expansion is around 6.5 million. which would cover capex and working capital. Projected cash flows are below. Sales are expected to grow by 15% for the first five years and 10% for another five. Beyond the forecasted period there is an assumed perpetual growth rate of 5%. The project was planned to be financed by 80% equity and 20% debt. At this time Herbo had almost no debt - To find WACC you need to estimate the cost of debt and equity. To find WACC you will need Beta. As Herbo is an unlisted company you can estimate the beta based on comparable firms numbers found in the numbers below. How does Capital Structure affect WACC? Perform a sensitivity analysis for WACC based on capital structure. - The most viable source of debt…arrow_forward
- Lana is thinking about making an iventment in a new venture called BluePearl - after performing an analysis of similar firms, she discovered several other firms (3) with the following Enterprise Value to FCF ratios: Firm 1: 5.9 Firm 2: 7.6 Firm 3: 9.1 The cashflows for BluePearl this year are expected to be $1,300,000. If BluePearl doesn't have any debt or cash currently, and 700,000 shares outstanding - what is the Price Per Share for BluePearl?arrow_forwardYou would like to estimate the weighted average cost of capital for a new airline business. Based on its industry asset beta, you have already estimated an unlevered cost of capital for the firm of 8%. However, the new business will be 28% debt financed, and you anticipate its debt cost of capital will be 7%. If its corporate tax rate is 31%, what is your estimate of its WACC?arrow_forwardGnomes R Us is considering a new project. The company has a debt-equity ratio of .72. The company’s cost of equity is 14.7 percent, and the aftertax cost of debt is 8 percent. The firm feels that the project is riskier than the company as a whole and that it should use an adjustment factor of +2 percent. a. What is the company’s WACC? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) b. What discount rate should the firm use for the project? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)arrow_forward
- Budget Wings Airlines is considering upgrading its fleet of aircraft as it expands from a regional airline to one offering service to a more nationwide portfolio of cities and airports. In support of this process, the CFO has asked you to determine the appropriate weighted average cost of capital (WACC) to use in the discounted cash flow analysis. You spend the morning gathering the following information: - Budget Wings has debt outstanding with a market value of $150 million. This debt is in the form of bonds that are currently priced at $946.33 per $1,000 face value and pay a coupon of 3.45%. The current yield-to-maturity (YTM) on these bonds is 4.11%. - Budget Wings stock is currently priced at $54.41 per share. You expect that next year's dividend will be $3.75 and you expect dividends to grow at 3%. The current market value of Budget Wings' common equity is $240 million. - Budget Wings has preferred equity outstanding with a market value of $30 million that offers an annual…arrow_forwardCompanies that use debt in their capital structure are said to be using financial leverage. Using leverage can increase shareholder returns, but leverage also increases the risk that shareholders bear. Consider the following case: Newtown Propane is a small company and is considering a project that will require $550,000 in assets. The project will be financed with 100% equity. The company faces a tax rate of 25%. What will be the ROE (return on equity) for this project if it produces an EBIT (earnings before interest and taxes) of $140,000? 15.27% 19.09% 21.00% 16.23% Determine what the project’s ROE will be if its EBIT is –$40,000. When calculating the tax effects, assume that Newtown Propane as a whole will have a large, positive income this year. -5.4% -5.67% -5.94% -6.48% Newtown Propane is also considering financing the project with 50% equity and 50% debt. The interest rate on the company’s debt will be 13%.…arrow_forwardOliva Corporation (OC) is planning to establish a new plant to produce olive oil in Kalamata under a new company named Kalamata Oliva Corporation (KOC). OC's unlevered beta is 1.5 and the tax rate is 25%. KOC's debt-to-equity ratio is 0.5. Considering that the risk-free rate is 3% and the market return is 10%, KOC's cost of equity is: Select one: a. 17.44% b. None of the proposed answers is correct c. 10.60% d. 22.50% e. 12.87%arrow_forward
- You are an analyst at Apex Innovations, known for its cutting-edge technology in the renewable energy sector. Apex is considering moving into high-energy batteries. You have been assigned to determine the leverage beta for this new division. Apex, plans to maintain a target debt-to-equity ratio of 1.88. We comparing other companies in the high-energy battery sector, you learned the average beta is 0.83 and the industry's average debt-to-equity ratio is 1.56. The tax rate for Apex and the high energy battery sector is 25%. What is the industry's unleverage beta? What is the new division's leverage beta?arrow_forwardGator Fabrics Inc. currently has zero debt (i.e., wd = 0). It is a zero growth company, and additional firm data are shown below. Now the company is considering using some debt, moving to the new capital structure indicated below. The money raised would be used to repurchase stock at the current price. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. If this plan were carried out, by how much would the WACC change, i.e., what is WACCOld − WACCNew?arrow_forwardYou would like to estimate the weighted average cost of capital for a new airline business. Based on its industry asset beta, you have already estimated an unlevered cost of capital for the firm of 10%. However, the new business will be 28% debt financed, and you anticipate its debt cost of capital will be 7%. If its corporate tax rate is 32%, what is your estimate of its WACC? The equity cost of capital is %. (Round to one decimal place.) The weighted average cost of capital is%. (Round to one decimal place.)arrow_forward
