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Suppose CAPM holds, and the beta of the equity of your company is 2. The expected market risk premium (the difference between the expected market…

b. P is higher than S.

  • NorthSouth Airlines has been granted permission to fly passengers between major U.S. cities. The new company faces competition from four airlines that operate between the major cities. The betas of the equity of the four major competitors (A, B, C, D) are 2.27, 2.55, 2.77, and 2.96; and the debt-to-equity ratios of these four companies (in the same order: A, B, C, D) are 0.22, 0.44, 0.62, and 0.77. Although these D/E ratios vary, all airline debt is rated the same. Suppose the yield on airline debt is 9.0%, the risk-free rate is 4.5% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 6.0%. What is the cost of capital (or discount rate) in percentage that you should use in valuing NorthSouth Airlines?

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