Consider the following airline industry data from mid-2009:
Company Name Market Capitalization Total Firm Value Equity Beta
(= Value of Equity)$mm $mm (= levered beta)
Delta Air Lines (DAL) 4,938.5 17,026.5 2.04
Southwest Airlines (LUV) 4,896.8 6,372.8 0.966
JetBlue Airways (JBLU) 1,245.5 3,833.5 1.91
Continental Airlines (CAL) 1,124.0 4,414.0 ?
a. Estimate the unlevered betas for DAL, LUV, and JBLU. Assume that the corporate tax rate for all of these airlines is 35%.
b. What is the average unlevered beta for the airline industry, based on your estimates from part a)?
c. Assume that Continental Airlines’ unlevered beta is the same as the industry average. What is the equity beta of Continental Airlines, assuming Continental is also subject to the 35% tax rate?
d. If the risk-free rate in the economy is 3% and the market risk premium is 6%, what is the required return on Continental’s equity according to the CAPM?
e. Southwest Airlines has a much lower equity beta than the other comparable airlines. Is this difference primarily due to a difference in business risk or a difference in financial risk? Explain briefly using your estimates from part a).