Boeing's Strategy
The Capital Assets Price Model (CAPM), is a model for pricing an individual security or a portfolio. Its basic function is to describe the relationship between risk and expected return, which is often used to estimate a cost of equity (Wikipedia, 2009). It serves as a model for determining the discount rate which is used in calculating net present value. The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. The formula is:
R = Rf + *(E(Rm)-Rf) Rf = Risk free rate of return, usually U.S. treasury bonds ( ) β = Beta for a company E(Rm) = Expected return of the market (commercial airlines market) E(Rm)-Rf = Sometimes referred to as the risk premium
The beta and risk-free rate should be selected as required according to the Boeing 7E7 case study. For the CAPM the risk free rate of return for a given period is taken to be the return on government bonds over the period. The risk free rate of return at the time of this case was 4.56% (Bruner, p. 239, 2007). At the time of the case, four main estimatesof equity market risk premiums (EMRP) were: 6.4% = Geometric mean over T-bills 4.7% = Geometric mean over T-bonds 8.4% = Arithmetic mean over T-bills 6.4% = Arithmetic mean over T-bonds
For the purpose of analysis we will use 6.4% EMRP, thus (E(Rm)-Rf) = 6.4 %.()
The cost of equity is determined by the company’s levered Beta (). This is calculated according to the ‘Hamada equation’: βl = βu (1+(1-T)(D/E)) βl = company’s levered Beta βu = company’s unlevered beta (It is a beta assuming the firm is completely equity financed, which reflects pure business risk)
T = effective marginal tax rate D/E = market-value debt/equity ratios
Exhibit 10 provided seven different betas that can be used for the capital assets price model and discount rate
R = Rf + *(E(Rm)-Rf) Rf = Risk free rate of return, usually U.S. treasury bonds ( ) β = Beta for a company E(Rm) = Expected return of the market (commercial airlines market) E(Rm)-Rf = Sometimes referred to as the risk premium
The beta and risk-free rate should be selected as required according to the Boeing 7E7 case study. For the CAPM the risk free rate of return for a given period is taken to be the return on government bonds over the period. The risk free rate of return at the time of this case was 4.56% (Bruner, p. 239, 2007). At the time of the case, four main estimatesof equity market risk premiums (EMRP) were: 6.4% = Geometric mean over T-bills 4.7% = Geometric mean over T-bonds 8.4% = Arithmetic mean over T-bills 6.4% = Arithmetic mean over T-bonds
For the purpose of analysis we will use 6.4% EMRP, thus (E(Rm)-Rf) = 6.4 %.()
The cost of equity is determined by the company’s levered Beta (). This is calculated according to the ‘Hamada equation’: βl = βu (1+(1-T)(D/E)) βl = company’s levered Beta βu = company’s unlevered beta (It is a beta assuming the firm is completely equity financed, which reflects pure business risk)
T = effective marginal tax rate D/E = market-value debt/equity ratios
Exhibit 10 provided seven different betas that can be used for the capital assets price model and discount rate