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? a.Under what circumstances is the project economically attractive? b.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?
In this weak economy, Boeing must seize considerable market share by developing the new 7E7. The 7E7 will have lower operating costs and will be the most versatile airplane on the market by implementing an adjustable wing. Boeing’s calculation for units sold in the next 20 years will prove the project to be profitable. 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 September 17, 2001. Both ended June 16, 2003. This data is highly skewed due to the events of September 11, 2001 and the subsequent deterioration of the airline industry. In this case, the extended length of the regression period is a detriment to the calculation of future risk. Due to the large beta, investors should expect greater returns than the stock market is providing. See Appendix A.
Risk Free Rate
US government debt is considered risk free as there is a miniscule chance, very near zero, that the US government will become insolvent. This is therefore the risk free rate that we will use for our calculations. The case gives us the rates of the 3-month Treasury Bill and the 30 year Treasury Bond at 0.85% and 4.56% respectively, in June 2003. Since this project has a time horizon on the order of 20-30 years it would be very reasonable to use the 30-year...