Southwestern Industries and Cactus Airlines

Southwestern Industries, a diversified industrial corporation, is considering an acquisition of Cactus Airlines, a small passenger air carrier that operates in the southwestern United States.

After the acquisition, Southwestern plans to have a target debt-to-equity (D/E) ratio of 0.15.

Cactus Airlines is quite similar in its size and operations to another company, Arizona Air.

You are given the following information:

? Risk-free rate = 4.3%

? Market risk premium = 8.4%

? Corporate tax rate = 35%

? Southwestern Industries: βE = 1, βD = 0, rD = 5.0%

? Cactus Airlines: βE = 1.5, βD = 0.3, (D/E) = 0.25

? Arizona Air: βE = 1.5, βD = 0.2, (D/E) = 0.25

A study of historical data reveals that Cactus Airlines maintains an essentially fixed amount of debt on its balance sheet, while Arizona Air does not. However, Arizona Air frequently rebalances its capital structure in response to the performance of its stock, and therefore maintains a relatively stable D/E ratio.

a) What are the unlevered asset betas of Cactus Airlines and Arizona Air?

b) Compute the WACC that Southwestern should use to discount the cash flows from the acquisition.