In order to evaluate the prospective IRRs from the Boeing 7E7, we first try to estimate an appropriate required rate of return for accepting this project. The capital asset pricing model is applied to estimate the cost of equity of the commercial aircraft division: R_EC= β_EC*(R_M-R_f )+R_f
where REC is the cost of equity capital of the commercial aircraft division. βEC is the beta for the commercial division of Boeing. This beta is used instead of the company’s overall beta is because the 7E7 project is a project on the commercial aircraft section. It will help to improve the evaluation process when comparing the WACC with the IRR. Rm is the market rate of return in US and Rf is the risk-free rate. According to Table 1 shown in the Appendix, the market rate of return for US large stocks between 1926 – 2005 is 12.15%, which is a statistical research done by CRSP. Since 2005 is close to our evaluation period 2003, we try to assume market rate of return equals to 12.15%. The risk-free rate used is the given 30-year Treasury bond yield, which is 4.56%. The long-term rate is used since we are now estimating a project which will have a long-term effect on the business. Thus, equity market risk premium (EMRP) is: 12.15%-4.56%=7.59%
For the beta of the commercial division, we try to derive it with the following formulas: β_U= 〖W_D*β〗_UD+〖W_C*β〗_UC
where βU is the unlevered beta of Boeing as a whole company. βUD is the unlevered beta of the defense aircraft division derived from other comparable firms. βUC is the unlevered beta of the commercial division. WD and WC are the weights given to the betas of defense and commercial divisions respectively. From Table 2, you can see our calculations of βUC. βUD of Boeing defense division is approximated by using the 5-year βU of Lockheed Martin and Northrop Grumman. The reason of using these 2 firms is because of their high revenue contributions from government (93% and 91%). That’s why we...