Question

	Levered Equity Beta	D/E Ratio	Debt Beta
A company	3.24	205.16%	0.3
B company	4.05	5663.67%	0.4
C company	-0.11	106.22%	0.3
Southwest Airlines	-0.01	14.93%	0.2

1. Estimate the unlevered equity beta for Southwest Airlines. You may assume a 38% tax rate in your calculations.

2. Based on your estimate of Southwest Airlines’ unlevered equity beta, relever the beta to get an estimate of the firm’s levered beta.

3. The airline industry was obviously in a very unique position at the end of 2006. Are there any special concerns that you have regarding the estimation of the cost of equity for Southwest Airlines using the procedure described here?

Answer 1

Relation between levered and unlevered equity beta:

Unlevered beta(asset beta)=levered beta(equity beta)/(1+(1-tax rate)*D/E)+debt beta/(1-t)+E/D

Unlevered beta(asset beta=-.01/(1+(1-0.38*.1493)+0.2/(0.62+6.6979)

Unlevered beta(asset beta)= -0.91528+.02733= -0.88795

Company A:

Levered Beta=[Unlevered beta-debt beta/(1-t)+E/D]/(1+(1-t)*D/E

Levered Beta=-.88795-0.3/(1+0.62*2.0516)= -1.01999

Company B:

Levered Beta=[Unlevered beta-debt beta/(1-t)+E/D]/(1+(1-t)*D/E

Levered Beta=-.88795-0.4/(1+0.62*56.63)= -0.89902

Company C:

Levered Beta=[Unlevered beta-debt beta/(1-t)+E/D]/(1+(1-t)*D/E

Levered Beta=-.88795-0.3/(1+0.62*1.0622)= -1.06883

c) Asset Betas are re-levered again to test the impact of multiple debt levels (proposed capital structure) to find an optimal mix between risk, returns and debt pay down schedules.

Kce=rf+Beat(Rm-Rf)

Here the beta is levered beta , as we have relevered the beta and found respective levered betas to find more realisitic imoact of market risk .