7e7 Dreamliner

Topics: Airbus A350, Boeing, Competition between Airbus and Boeing Pages: 5 (2120 words) Published: April 28, 2013
Q1. I started with picking up a relevant risk-free rate (Rfr) for the CAPM to calculate the cost of equity; I learned that 10 years T-Bond rate was more appropriate rate to be utilized for the sake of Rfr; the reasons cited in the reading “Best Practices in Estimating the Cost of Capital: Survey and Synthesis” made sense that the long-term bond yields more diligently replicates the default free HPR available on long term investments and hence more closely reflects the different investing decisions made by the firms1. Therefore, I have selected Rfr of 4.05% on 10 years T-Bonds on January 1, 20032. The real challenge for me was to pick a more appropriate equity risk premium (ERP), and I came across more than conflicting information on what number I should utilize for this purpose. As majority of the analysts, professors and textbooks have used MRP from a range of to 5% to 7.4%3. Moreover, most of the people said that they would utilize the “Arithmetic Historical Averages” for the ERP. Digging deep the issue of ERP, I came across few significant findings by Pablo Fernández and Aswath Damodaran. Fernández has conducted number of surveys and research on the appropriate ERP and comes up to a conclusion that there is no appropriate ERP for a market as whole and also that using the historical averages would not be suitable, since a lot has changed in the investment world and over the years the ERP has been seen to slide down from the historical averages4. Aswath Damodaran (2001), in his book “The Dark Side of Valuation” argues that the use of geometric average risk premiums (6.05%) for stocks over the T-Bonds the period of 1928-1999, poses serious questions and if someone uses them they are assuming that there have been no trends in the risk premiums and inherent risks of the market are the same as they were few decades ago. Aswath Damodaran in his research argues that although there is no right way to calculate the ERP, however using arithmetic averages will seriously temper the valuation purpose5. First, the arithmetic averages yield a higher number, which will make the investment look overvalued and companies, will not invest in the projects. He further has calculated the ERP (3.97%) from implied expected equity return of stocks on January 1, 2003 (The Equity Risk Premiums: Looking backwards and forwards). His findings were second by Pablo Fernández, when he cited the ERP calculated by the Roger G. Ibboston and Peng Chen of Morning Star to be 3.97% by using 3 Factor Earning Model: Forward Looking Earnings6. That was the reason I have used ERP of 3.97% in my calculations and tried to avoid the trap of historical averages of ERP. To calculate the required rate of return for the Boeing’s “7E7 Dreamliner” project, it was necessary to understand the operations of the company as a whole and come up with a relevant required rate, which was applicable to the Boeing’s commercial airlines business segment and was not based on firm wide risk profiling. This risk profiling of a commercial airline segment made sense because the risk, which was face by the other segment (defense and space industry) of the firm was much lower compared to the commercial airline segment. I used the beta of 1.17 for Boeing calculated against the NYSE composite index for 21 months. In my opinion, the 60 days trading beta was too high because of the recent uncertainties in the global environment and exogenous shocks. On the flip side, the 60 months beta was not inculcating the recent risks, which the airline industry has faced in the aftermaths of 9/11, and downward shift in business cycles. Since the good old days for Boeing have passed and now, the company has to make extra efforts to recapture the share of commercial airline industry from the Airbus. I have also separated the asset betas of commercial and defense segments for Boeing and have calculated the equity beta of Boeing’s commercial by utilizing the asset beta of defense from firms, which were...
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