October 15th, 2009
Cost of Equity1
Equity Market Risk Premium1
Risk Free Rate2
Capital Structure Weights2
Boeing 7E7 Project Evaluation4
Circumstances for an economically attractive project4
Board approval for the project?7
This report seeks to answer the following three questions about the Boeing 7E7 project: 1. What is an appropriate required rate of return against which to evaluate the prospective IRRs from the Boeing 7E7? a. Please use the capital asset pricing model to estimate the cost of equity. b. Which equity market risk premium (EMRP) did you use? Why? c. What Beta did you use and how did you derive it?
d. Which risk-free rate did you use? Why?
e. Which capital-structure weights did you use? Why? 2. Judged against your WACC, how attractive is the Boeing 7E7 project? f. Under what circumstances is the project economically attractive? g. What does sensitivity analysis (your own and/or that shown in the case) reveal about the nature of Boeing’s gamble on the 7E7? 3. Should the board approve the 7E7?
The analysis identifies both risks and benefits associated with undertaking the 7E7 project. Giving a calculated WAAC of 15.44% for the commercial division of Boeing, the project is feasible and profitable. As you will find, the financial calculations provided in this report show that the project will increase the wealth of the shareholders, also identifying the associated risks and how those could be minimized. Assuming the development costs are correctly estimated and the market response is properly gauged, the reasons to go forward with the project outweigh those against it. The market competition corroborated with the unfavorable economic conditions prompt a swift and decisive answer from Boeing. The new 7E7 will have lower operating costs due to increased cargo space and increased fuel economy due to new engine design, would also be versatile and suitable for both short and long flight routes. Ensuring the development and manufacturing costs are kept down by employing decades of engineering expertise and already proven technologies and solutions, it is recommended that Boeing undertakes the 7E7 project.
Cost of Equity
The 7E7 Project is a risky project. With a beta of 2.540738, which is substantially higher than the stock market average company, volatility is expected in this investment. However, with risk comes a reward. The 7E7 project would need to provide returns of 22.7009% in order to be considered a sound investment. E(Ri) = .0456+ 2.540738 [.117 - .0456]
E(Ri) = .0456+ 2.540738 [.0714]
E = 22.7009%
Equity Market Risk Premium
The equity market risk premium should equal the return expected by investors on a market portfolio relative to riskless assets. We have decided to use the 30-Year Treasury Bond as the risk free return because it most closely mimics the time horizon of the 7E7 project. The expected rate of return of a market portfolio of stocks is estimated at 11.7%. This is the estimate used by Brealey and Meyers, and is comprised of total market returns from 1900-2006. Therefore the equity market risk premium is equal to 7.14%. (11.7% - 4.56% = 7.14%) Beta
Risk is inherent in the economy and equity markets and the 60 trading day Boeing BetaEquity calculated against the S&P 500 Index would be a most accurate predictor of future risk. Due to the length of the Boeing project, at first glance it would appear a beta calculated using a longer regression period would estimate future returns best. The 60 month beta regression period began June 16, 1998. The 21 month beta period began...