Estimation of Cost of Capital

Case: The Boeing 7E7

We still have a lot to get done as we move
toward authority to offer the 7E7 to our
customers
The team is making great progress—
understanding what our customer wants,
developing an airplane that meets their
needs, and defining a case that will
demonstrate the value of the program
—Michael Bair, Boeing Senior Vice President
SFAS No. 142
717
737
757
747
767
777
Integrated Defense Systems
Lockheed Martin
Demand for Commercial Aircraft
• The long-term outlook for aircraft demand seemed positive • Exhibit 5 illustrates Airbus’s 20-year predictions for the years
• The primary sources for commercial-aircraft demand estimates 2000–2020
included Boeing’s 2003 Current Market Outlook and Airbus’s • Although the report was dated 2002, because of the September
2002 Global Market Forecast 2001–2020 11 attacks, numbers included the year 2000, to serve as a
• While both reports recognized the negative effects of benchmark year
“exogenous events” such as September 11, 2001, they both • For that period, Airbus predicted the delivery of 15,887 new
agreed on a healthy long-term outlook commercial aircraft in 2002, with a value of (U.S. dollars) $1.5
• Boeing’s Market Outlook said the following: trillion
• In the short term, air travel is influenced by business cycles, • This included 10,201 single-aisle aircraft; 3,842 twin-aisle
consumer confidence, and exogenous events aircraft; 1,138 very large aircraft, and 706 freighters
• Over the long-term, cycles smooth out, and GDP, international • The 15,887-unit forecast did not include planes with less than 90
trade, lower fares, and network service improvements become seats
paramount • Although Boeing and Airbus’s numbers are not directly
• During the next 20 years, economies will grow annually by 3.2%, comparable due to the slightly different time periods and aircraft
and air travel will continue its historic relationship with GDP by classifications, it appeared that Airbus was more optimistic about
growing at an average annual rate of 5.1% the market for large aircraft than Boeing was
• As shown in Exhibit 4, Boeing’s 20-year forecast from 2003 to • While Airbus predicted it to be a $270 billion market, including
2022, was for 24,276 new commercial aircraft in 2002, valued at 1138 passenger units, Boeing projected only $214 billion with
$1.9 trillion 653 passenger units
• The company predicted a composition of 4,303 smaller regional • Boeing, however, estimated that the share of intermediate-sized
jets (fewer than 90 seats); 13,647 single-aisle airplanes; 5,437 planes would increase from 18% to 22%
intermediate twin-aisle airplanes; and 889 747-size or larger • In its forecast, Boeing acknowledged that intermediate-sized
airplanes airplanes would economically allow airlines to fly the increased
• This prediction reflected a world fleet that would more than frequencies, city pairs, and nonstop flights requested by
double, with one-fourth of the market coming from aircraft passengers
replacement and three-fourths from projected passenger and • According to a recent study by Frost & Sullivan, they believed
cargo growth that the Airbus market projection for the A380 was “over-
optimistic”
Business Cycles
Consumer Confidence
Exogenous Events
GDP
Aircraft Development and Lifecycle
• The development of a new • Over time, survival in the industry
airframe was characterized by depended on introducing
huge initial cash outflows that successful products and having
might require between one and the deep financial pockets with
two decades to recoup which to survive the initially
• For example, the development gushing cash flow
costs for the Boeing 777 were • While aircraft sales were subject
rumored to be $7 billion to short-term, cyclical deviations,
• Any pricing would not only have to there was some degree of
recoup the upfront development predictability in sales
costs but also the production costs • Sales typically peaked shortly after
• In addition, pricing would be the introduction of the new
subject to rigorous, competitive aircraft and then fell
pressures • Thereafter, sales would rise and
• In short, because of the financial fall as derivatives of the aircraft
strains a new product line might were offered
create, each new aircraft was a • Exhibit 6 shows the cycles for the
“bet the ranch” proposition first 20 years of the 757 and 767
sales
Bet the Ranch
Aircraft Development Costs
Derivatives of the Aircraft
Boeing 7E7
• The concept of the Boeing 7E7 was driven by • Based on discussions with over 40 airlines
customer requirements throughout the world, Michael Bair identified a
• Boeing originally announced in March 2001, its fresh market to replace midsized planes, based
plans to build the Sonic Cruiser, a plane that not only on lower operating costs, but also on the
would fly just below the speed of sound creation of a midsized plane that could travel
• The success of the Cruiser depended on whether long distances, a feat previously viable by only
passengers would pay a premium for a faster large planes, such as the 747
flight; however, potential airplane customers who • Such flexibility would allow airlines to offer
had been interested in the Cruiser during a nonstop service on routes that required long-
robust, commercial-air travel market were now range planes but did not justify the subsequent
focusing on survival larger size
• The events of September 11 and the bursting of • Bair estimated there to be more than 400 city
the technology bubble led to a significant decline pairs (e.g., Atlanta–Athens) that could be served
in airplane orders efficiently on a nonstop basis by the 7E7
• As a result, Boeing solicited updated feedback • Boeing was considering two new members for
from a number of potential customers who the 7E7 family, a basic and a stretch version
would soon need to replace their aging fleet of • Exhibit 7 gives Boeing’s description of the two
midrange planes, such as the 757s, 767s, A300s, configurations
A310s, A321s, and A330s • Other improvements for passengers included
• Overwhelmingly, the revised message from wider aisles, lower cabin altitude, and increased
customers was for a plane with lower operating cabin humidity
costs
Boeing 7E7
• In addition, the planes would include systems • Furthermore, if the range flexibility did require
that provided in-flight entertainment, Internet snap-on wings, such a design may significantly
access, real-time airplane systems and structure increase the building costs of the aircraft
health monitoring, and crew connectivity • Not only did Boeing face the engineering
• Furthermore, Boeing claimed the 7E7 would have uncertainty of being able to deliver such an
the smallest sound “footprint” with the quietest aircraft, but also the risk of its duplication by
takeoff and landing in its class Airbus
• Boeing projected a demand for between 2000 • Airbus had already stated that if the fuel
and 3000 planes of the 7E7 type within 20 years efficiency was primarily generated by new engine
of each one entering service designs, then it would simply order the more
• A study by Frost & Sullivan predicted the sale of efficient engines for its planes
“at least 2000 B7E7s” • Any uncertainty in the 7E7 plane specifications
• However, the demand was highly dependent on and risk of competition clearly put downward
whether Boeing could deliver the promised 20% pressure on both the price Boeing could demand,
cheaper fuel costs and the range flexibility in a as well as the number of units it would be able to
mid-size aircraft sell
Financial Forecast and Analysis
• Exhibit 8 contains a 20-year forecast of free cash • Using this methodology, without any premium
flows from the Boeing 7E7 project consistent for the promised lower operating costs, the
with public information released by Boeing, minimum price for the 7E7 and 7E7 Stretch was
Airbus, analysts, and other experts in the field estimated to be $114.5 million and $144.5
• See the Appendix for detailed forecast million, respectively, in 2002
assumptions • The forecast assumed that customers would be
• The primary implication of the forecast is that the willing to pay a 5% price premium for the lower
7E7 project would provide an internal rate of operating costs
return (IRR) close to 16% • The IRR, which is consistent with base case
• This assumes that Boeing would not only deliver assumptions, was 15.7%
the promised plane specifications, but that Airbus • But, the estimate of IRR was sensitive to
would be unable to replicate the 7E7 efficiencies variations in different assumptions
• Based on both analysts’ and Boeing’s • In particular, some obvious uncertainties would
expectations, the base case assumes that Boeing be the number of units that Boeing would be able
could sell 2,500 units in the first 20 years of to sell and at what price
delivery • For example, if Boeing only sold 1,500 units in the
• Pricing was estimated using 2002 prices for first 20 years, then, as shown in Exhibit 9, the IRR
Boeing’s 777 and 767 would drop to 11%
• The 7E7 would be a hybrid of the two planes in • This might occur if air travel demand worsened,
terms of the number of passengers and range or if Airbus entered this segment with a new
• By interpolating between the 777 and 767 prices, competing product
it was possible to estimate the value placed on
the range and number of passengers
Financial Forecast and Analysis
• Additional unknown variables were the • On the one hand, engineers were
development costs and the per-copy costs challenged to build a midsized aircraft with
to build the 7E7 long-range capabilities
• Boeing’s board was anxious to minimize • The engineering design to achieve this
those costs could push building costs up significantly.
• The forecast assumes $8 billion for Conversely, if Boeing succeeded in using
development costs; however, analyst composite materials, which required a
estimates were in the $6 billion to $10 fraction of the normal assembly time, then
billion range construction costs would be lower
• The cost to manufacture the 7E7 was also • Consistent with Boeing’s history, the base
subject to great uncertainty case assumes 80% as the percentage of
cost of goods sold to sales
• As shown in Exhibit 9, however, the IRR of
the 7E7 was very sensitive to keeping
production costs low
Operating Costs in Airways
Sonic Cruiser
Boeing 757
Boeing 767
A300
A310
A321
A330
Cost of Capital
• Boeing’s weighted-average cost of capital • Defense corporations were the beneficiaries
(WACC) could be estimated using the when the world became unstable due to the
following well-known formula: terrorist attacks on September 11, 2001
• WACC = (Percent Debt)(rd)(1 – tc) + (Percent • Furthermore, the United States, along with
Equity)(re) some of its allies, went to war against Iraq on
March 20, 2003
• where:
• Exhibit 10 gives information about betas and • While Bush declared an end to major Iraqi
debt/equity ratios for Boeing and combat operations on May 1, 2003, as of
comparable companies June 16, the death toll in Iraq continued to
rise on a daily basis
• Exhibit 11 provides data about Boeing’s
outstanding debt issues • A different type of risk emanated with the
outbreak of SARS
• While Boeing’s marginal effective tax rate
had been smaller in the past, it currently was • On February 1, 2003, China announced the
expected to be 35% discovery of the deadly and contagious
illness that subsequently spread to Canada
• In June 2003, the yield on the three-month and Australia
U.S. Treasury bill was 0.85%, and the yield on
the 30-year Treasury bond was 4.56% • As of June 16, travel warnings were still
outstanding
• On June 16, 2003, Boeing’s stock price closed
at $36.41 • Thus the question arose of whether one
should estimate Boeing’s cost of capital to
• Analysts pointed out that Boeing actually serve as a benchmark-required rate of return
consisted of two separate businesses: the
relatively more stable defense business and
the conversely more volatile commercial
Conclusion
• Within the aircraft-manufacturing industry, the • Central to any recommendation that Bair
magnitude of risk posed by the launching of a would make to Boeing’s board of directors was
major new aircraft was accepted as a matter of an assessment of the economic profitability of
course the 7E7 project
• With huge, upfront, capital costs in an • Would the project compensate the
environment of intense technology and price shareholders of Boeing for the risks and use of
competition, there was no guarantee of their capital?
success or major significant losses if the • Were there other considerations that might
gamble did not pay off mitigate the economic analysis
• At a time of great political and economic • For instance, to what extent might
uncertainty, Michael Bair said: organizational and strategic considerations
• Clearly, we have to make a compelling business influence the board?
proposition • If Boeing did not undertake the 7E7, would it
• It could be [that] we’ll still be in a terrible be conceding leadership of the commercial-
business climate in 2004 aircraft business to Airbus?
• But you can’t let what’s happening today
cause you to make bad decisions for this very
long business cycle
• This plane is very important to our future
Discussion Question

Would the project compensate the shareholders

of Boeing for the risks and use of their capital?
Discussion Question

Were there other considerations that might

mitigate the economic analysis?
Discussion Question

For instance, to what extent might

organizational and strategic considerations
influence the board?
Discussion Question

If Boeing did not undertake the 7E7, would it be

conceding leadership of the commercial-aircraft
business to Airbus?
Discussion Question

Would a required return on a portfolio of those

two businesses be appropriate for evaluating
the 7E7 project?

If necessary, how might it be possible to isolate a

required return for commercial aircraft?
Assumptions Underlying the Forecast of Cash
Flows
• In order to project revenues for the project, • Exhibit 6 uses an historical average of the 757
several assumptions were made about the and 767 unit sales during their first 20 years
expected demand and timing for the units, their • The Boeing 7E7 is expected to be a replacement
price, and price increases aircraft for the 757 and 767
• Demand • Analysis assumes the 7E7 Stretch accounts for
• Boeing estimated that in the first 20 years they only 20% of unit sales in its first year of delivery
would sell 2,000–3,000 units and 50% thereafter
• Frost & Sullivan, aviation industry analysts, • If the total number of unit sales per year is an
predicted at least 2,000 units odd number, the 7E7 units are rounded up and
• Analysis assumes 2,500 units in years 1 through the 7E7 Stretch are rounded down
20 • Price
• Years 20–30 assume unit sales equal to year 20 • The expected price of the 7E7 and Stretch version
• First delivery of 7E7 expected in 2008 and 7E7 is a function of the 767 and 777 prices in 2002
Stretch in 2010 • Using range and capacity as the primary
• Timing of demand variables, the 7E7 and 7E7 Stretch would be
• Units sold per year is the percentage of the total expected to have a minimum price of $114.5
units in the first 20 years as shown in Exhibit 6 million and $144.5 million respectively in 2002
dollars
• This does not include a premium for the expected
lower operating costs and flexibility of the 7E7
• The analysis assumes a 5% price premium as a
benchmark, resulting in expected prices of
$120.2 million and $151.7 million in 2002
Assumptions Underlying the Forecast
of Cash Flows
• Rate of price increases • Depreciation
• Aircraft prices are assumed to increase at the rate • Boeing depreciated its assets on an accelerated
of inflation basis
• Inflation is assumed to be 2% per year until 2037 • The forecast uses 150% declining balance
• Expense Estimation depreciation with a 20-year asset life and zero
• Cost of goods sold salvage value as the base
• The average cost of goods sold for Boeing’s • Research and development as a percentage of
commercial-aircraft division was 80% over the sales
three-year period 2000–2002 • The average research and development expense
• The range was 77.9% to 81.1% for Boeing’s commercial-aircraft division as a
percentage of commercial-aircraft sales was 2.3%
• The analysis assumes 80% as the COGS over the three-year period 2000–2002
• General, selling, and administrative expense
• The range was 1.8% to 2.7%
• The average general, selling, and administrative
• During that period, Boeing did not have any
expense for Boeing was 7.5% over the three-year extraordinary new commercial-aircraft
period 2000–2002 development expenses
• The range was 7.4% to 7.7% • The analysis, therefore, assumes 2.3% as the
• The analysis assumes 7.5% as the general, selling, estimated research and development expense
and administrative expense • That does not include the initial research and
development costs required to design and
develop the 7E7
Assumptions Underlying the Forecast
of Cash Flows
• Tax expense • The years prior to 2000, Boeing had positive
• Boeing’s expected marginal effective tax rate was working capital
35% • The 1997–1999, three-year average of working
• Other Adjustments to Cash Flow capital as a percentage of sales is 6.7% with a
• Capital expenditures range from 3.5% to 11.2%
• The 1998–2002 average for capital expenditures • The analysis assumes this percentage
as a percentage of sales was 0.93% • Initial development costs
• During this period, Boeing did not have any • Development costs include the research and
extraordinary new commercial-aircraft capital requirements needed to design and build
development expenses the 7E7
• At the time, Boeing had six families of aircraft: • Analysts estimated between $6 billion and $10
the 717, 737, 747, 757, 767, and 777 billion
• The average capital expenditures per family line, • The analysis assumes $8 billion
as a percentage of sales, was therefore 0.16% • Assuming a launch in 2004, analysts expected
• This does not include the initial capital spending to peak in 2006
expenditure costs required to develop and build • Timing of the development costs are assumed to
the 7E7 be 2004: 5%, 2005: 15%, 2006: 50%, 2007: 15%,
• Change in working capital requirements (WCR) 2008: 10%, and 2009: 5%
• For the years 2000–2002, Boeing had negative • It is estimated that 75% of the initial
working capital due to factors such as advance development costs are research and
customer payments development expenses, while the remaining 25%
• The analysis assumes that the commercial are capital expenditures
segment of Boeing would require positive
working capital
Synopsis
• In 2003, the Boeing Company announced plans to • Estimate a weighted-average cost of capital
build a new “super-efficient” commercial jet (WACC) for Boeing’s commercial-aircraft business
called the 7E7 or Dreamliner segment in order to evaluate the IRRs
• This was a “bet the farm” gamble by Boeing, • As a result of that analysis, identify the key value
similar in magnitude to its earlier introductions of drivers and distinguish, on a qualitative basis, the
the 747 and 777 airliners key gambles that Boeing is making
• The technological superiority of the new • Estimating a WACC and cost of equity
airframe, as well as the fact that it would • Estimate a segment WACC draws out abilities to
penetrate a rapidly growing market segment, critique different estimates of beta and to
were arguments for approval of the project manipulate the levered-beta formulas
• On the other hand, the current market for • Boeing competes in both the commercial aircraft
commercial airplanes was depressed because of and the defense business
terrorism risks, war, and SARS, a contagious
• Thus deriving the appropriate benchmark WACC
illness that resulted in global travel warnings for the 7E7 project requires isolating the
• Boeing’s board of directors would need to weigh commercial aircraft component from Boeing’s
those considerations before granting final overall corporate WACC
approval to proceed with the project
• The task for students is to evaluate the 7E7
project against a financial standard, the investors’
required returns
• The case gives internal rates of return (IRR) for
the 7E7 project under base-case and alternative
forecasts
Bet the Farm Gamble
Value Additivity
Segment WACC
Risk Free Rate
CAPM
IRRs
Discussion Question
What is an appropriate required rate of return against which to
evaluate the prospective IRRs from the Boeing 7E7?

Please use the capital asset pricing model to estimate the cost of
equity
At the date of the case, the 74-year equity market risk premium
(EMRP) was estimated to be ___
Which beta and risk-free rate did you use? Why?
When you used the capital asset pricing model, which risk-
premium and risk-free rate did you use? Why?
Which capital-structure weights did you use? Why?
Equity Market Risk Premium (EMRP)
Discussion Question
Judged against your WACC, how attractive is the
Boeing 7E7 project?

Under what circumstances is the project

economically attractive?

What does sensitivity analysis (your own and/or

that shown in the case) reveal about the nature of
Boeing’s gamble on the 7E7?
Sensitivity Analysis
Discussion Question

Should the board approve the 7E7?

Discussion Question

Why is Boeing contemplating the launch of the

BE7 project?
Is this a good time to do so?
EMRP
• The four main estimates of EMRP were:
• Geometric Mean over T-Bills: 6.4%
• Geometric Mean over T-Bonds: 4.7%
• Arithmetic Mean over T-Bills: 8.4%
• Arithmetic Mean over T-Bonds: 6.4%
Discussion Question

Should Boeing’s board approve the 7E7?

Devil’s Advocate Approach
Discussion Question

How would we know if the 7E7 project will

create value?
IRR and WACC
• If the IRR is greater • The project IRRs are
than the project cost presented in case
of capital, the 7E7 is Exhibit 9
a positive net present • Determining the
value project benchmark against
• Of course, this which to evaluate the
assumes initial IRRs
negative cash flows
followed by positive
cash flows
Discussion Question

How to estimate the WACC?

Discussion Question

How can there be a range of cost of capital

estimates?
Discussion Question
Have we thought of everything Is there any thing
else the board of directors should consider in
assessing the financial appeal of this project?

Why might the board vote “yes” on the 7E7, when

the cost of capital estimate is greater than the IRR?

Why might the board vote “no” if the cost of capital

estimate is less than the IRR?
WACC?
• Determinate cash flow • The potential significance of
forecasts do not capture qualitative issues can be an
contingent values eye-opening point for who
• Real option valuation is consider finance to be a
beyond the scope of this case, “numbers” class
know that a large capital • In the end, the board of
project such as the 7E7 is directors must weigh both the
probably riddled with rights determinate cash flow values
that can enhance the value of and the contingent and
the project—rights to new yet- intangible values in the project
to-be discovered technology,
rights to grow and/or enter
new markets, and rights to
cross-pollinate other projects’
new intellectual property from
the 7E7
• In addition, the 7E7 might
Board’s Decision
• The motives for the project are laudable: the 7E7 • Here, the timing could not be worse: war, airline-
is entering a good growth segment of the focused terrorism, SARS, and the weak financial
industry condition of airlines all challenge the approval of
• Higher performance and fuel efficiency will the project
position Boeing favorably in the market, and • “Why now?” is a question that the board must
perhaps, take back some market share from answer. In part, the answer depends on the long
competitors development cycle (four years) and very long
• R&D on this project may create inventions that product lifecycle (20 years)
will prove to be valuable to other Boeing • The board is making a bet less on conditions that
products prevail today than on conditions that are
• At the same time, the consequences of error are expected to prevail many years into the future
staggering: this is a bet-the-ranch kind of
investment
• But, as most entertainers know, timing is
everything
Development of the 7E7 Project
Calculating WACC
• WACC = (% debt)(rd)(1 – tc) + • Many analysts simply
(% equity)(re) approximate market value of
• rd = required rate of return of debt with its face or book
debt value
re = required rate of return on • For floating-rate debt issues
equity (cost of equity) (such as bank loans) market
tc = marginal effective value will equal book value
corporate tax rate • For fixed-rate issues, book
% debt = debt divided by sum value may be a close
of debt plus equity, measured substitute for market value,
at market value where the bond was issued at
• % equity = equity divided by face value, and the credit
sum of debt plus equity, quality of the issuer and the
measured at market value general level of interest rates
• Market value of equity is have not changed since date of
simply share price times issue
number of shares
Discussion Question

Why the capital asset pricing model is not used

to estimate the firm’s cost of capital directly?
Calculating Cost of Equity
• re = rf + βe (rm –rf) • In theory, one could derive a beta
• where rf is the risk-free rate for debt and a beta for equity and
then weight them according to the
• rm – rf is the market-risk premium market values of their securities—
• βe is the beta of equity this should give an estimate for
• Simplicity is deceptive the firm’s asset beta
• Choice of models • Alternatively, one could unlever
the equity beta to get an asset
• A true asset beta is unobservable beta
because the items on the left-
hand side of the balance sheet are • Inserting the asset beta into the
ordinarily not traded in liquid CAPM would, in theory, yield an
markets estimate of the firm’s cost of
capital
• But these latter two methods
Invite estimation error.
• A survey of “best practice” firms,
how ever, revealed a total
preference for using the WACC
formula and for restricting CAPM
Discussion Question

How to estimate the WACC?

Discussion Question

The WACC is a simple formula. Yet it seems that

reasonable people will disagree about the
estimates

What are the points of contention in estimating

the cost of capital?
Discussion Question

Whether to estimate beta across the 60-day, 21-

month, or 5-year period?
Beta for the 7E7 project
• The tendency of novices will be to use Boeing’s • Measuring the return on the global asset
equity beta from case Exhibit 10 as an input to portfolio is, as a practical matter, proxied by
the CAPM returns on equity market indexes
• This would be inappropriate since this would • In bridging theory with practice, the greater the
assume that Boeing’s commercial aircraft risk is value captured by the index, the more closely it
equal to Boeing’s firm risk; however, Boeing’s matches the theory
firm risk is a blend of both commercial and • In case Exhibit 10, students have a choice
defense risk between the New York Stock Exchange (NYSE)
• Somehow, for the cost of capital to be meaningful composite index and the S&P 500 index
we have to back out the commercial risk from the • Of those two, the NYSE is a broader and higher
defense risk and use a beta reflecting commercial value index
risk in the CAPM
• This provides a beta range between 1.00 and 1.62
• Whether one would expect a commercial beta to
• Whether to estimate beta across the 60-day, 21-
be higher or lower than a defense beta and why month, or 5-year period?
—a strong case could be made that defense
would have a lower beta, reflecting the zero • Beta is the market’s instantaneous perception of
default risk of Boeing’s government clients and risk and moves on a second by second basis just
the long cost-plus contracts like stock prices
• Estimates of beta
• Case Exhibit 10 poses two basic choices
• first, what to use as a proxy for the market when
regressing equity returns on market returns; and
second, over what period of time the beta should
be measured
• Ideally, beta should be derived by regressing
Boeing’s equity return against the return on the
basket of global assets (i.e., the market return)
Discussion Question

What historic period best reflects the risk of the

commercial aircraft industry as perceived by the
market at the time of the decision?
Beta for the 7E7 project
• Yet since this is unobservable, we are forced to • What time period to use as it relates to the
use historic data to estimate the market’s commercial-aircraft industry?
perception of risk today • Only productive after doing sensitivity analysis
• Using a 60-day beta regression includes the with the different betas
trading dates between March 20 and June 16, • For now, this is a benchmark case, and it is only
2003 important to keep track of all assumptions
• This time period includes the Iraq war as well as • For purposes of illustration, this note uses the 60-
the peak of the SARS travel warnings day beta of 1.62
• The 21-month beta runs from September 17,
2001, and therefore has significantly more
terrorism risk
• The 60-month beta dilutes terrorism, war, and
SARS risk by going as far back as June 16, 1998
Calculating a Beta for Boeing’s
Commercial Division
• Step 1: Use the unlevered beta formula to • Case Exhibit 10 shows defense betas for Northrop
determine what the beta would have been if Grumman and Lockheed Martin, which both have
Boeing had no debt over 90% of their revenues coming from defense
• If Boeing had no debt, then the unlevered beta • If we assume that they are 100% in the defense
on the right-hand side of the balance sheet business then we can use their betas to proxy for
would be equal to the beta on the left-hand side: defense
Boeing’s asset beta • Use the 60-day NYSE betas to be consistent with
• Step 2: Boeing’s asset beta is a weighted average the earlier steps in the example
of its commercial and defense beta • The relevant betas are 0.34 and 0.27
• The formula assumes riskless debt and that the • Some students may be tempted to average these
only impact of debt on the value of the firm is the levered betas—but doing so would reflect the
corporate debt tax shield financing decisions of the peer firms and not that
• The formula for the debt tax shield (tcD) assumes of Boeing
permanent debt and that the company will be
permanently profitable enough to use the tax
shields
• To solve for the commercial Boeing beta, it is
necessary to determine a defense beta and to
decide how to estimate the percentage division
weights
• Weights for defense and commercial segments
• Case Exhibit 1 shows Boeing’s revenues,
operating profits, and identifiable assets broken
up by the commercial and defense segments
• Each of those measures has advantages and
disadvantages as a proxy for the market value of
assets.
Calculating a Beta for Boeing’s
Commercial Division
• What the calculation requires is the unlevered • While this is technically correct, you would not be
beta of the defense segment using market-provided information on debt at the
• Therefore, the betas of Lockheed and Northrop time of the case
must be unlevered and then averaged • Hence, a superior approach would be to relever
• It makes sense to average Lockheed Martin and the 2.03 to obtain a beta to use in CAPM to
Northrop Grumman betas of 0.29 and 0.21 calculate the cost of equity based on commercial
respectively—this simply draws on the greater risk
information embedded in two (rather than, one) • Calculating cost of equity
observations • Capital-asset pricing theory gives no guidance
• The average is 0.25 about which risk-free rate of return to use
• The two peer betas are less than 0.1 apart, • The case includes both a three-month and a 30-
relatively tightly clustered year choice of Treasury rates in June 2003
• Defense business to have a lower beta than the • Longer-term rate is warranted to match the
commercial business length of the project default is less likely in the
• Beta for commercial segment shorter term, so a short-term rate more closely
matches the theory
• The commercial beta is 2.03, greater than the
defense segment betas as expected • The calculation of WACC uses as the risk-free rate
• At this point, the 2.03 commercial beta is the three-month T-bill rate in June 2003 of 0.85%,
unlevered which results in a WACC of 16.7%
• If you applied this beta to the CAPM, you would • The WACC would change to 15.6% if the 30-year
be obtaining a discount rate for the commercial T-bond rate were used (based on the arithmetic
aircraft business, and there would be no need to equity risk premium)
use the WACC formula
Estimating WACC
• In theory, the CAPM reflects the market’s • A caveat in the calculation is that case Exhibit 11
assessment of the premium today does not include all Boeing’s debt
• Similar to beta, current practice uses historic data • It is missing short-term debt as well as debt
to make this estimate issued by Boeing’s financing subsidiary: Boeing
• Hence, the time period over which the average is Capital Corporation
measured can be subject to meaningful judgment • In theory, a weighted average of all debt reflects
• For example, does the last 20 years or last 74 the debt component risk on the left-hand side of
years better reflect the market’s assessment of the balance sheet
the premium today? • In practice, the yields of debt issued by Boeing
• The largest variation in estimates is due to Capital would be accessible information, and this
assumptions about beta and the equity market compromise in the calculation would not be
risk premium necessary
• Estimates span the values from 10.19% to 28.65% • Given this caveat, some interesting questions can
• Calculating the cost of debt (rd) be asked:
• Case Exhibit 11 provides the information needed • While this point is perfectly valid, it is much less
to calculate Boeing’s cost of debt The approach is of an issue than equity since debt is a senior
to use a market value weighted average of yields security
to maturity of Boeing’s different debt issues as of • While the beta of each debt issue is possible to
June 2003 estimate if it is traded publicly, and while CAPM is
not restricted to equity instruments in theory,
solving for a bond’s yield to maturity (YTM) using
existing market data avoids all the assumptions
and weaknesses inherent in CAPM
Discussion Question

Is debt not also subject to commercial and

defense risk, and should we there fore not try to
backout the commercial risk component?
Discussion Question

Why not simply use the CAPM to estimate the

cost of debt?
Estimating WACC
• The only reason we are forced to • This compares to 5.33% using a
use a model like CAPM in weighted average of all available
estimating equity is that, unlike a debt information
bond instrument where coupon • This would change the WACC from
and principal payments are known the base case of 16.7% to 16.9%
with a fair degree of certainty, we
do not know what cash flows to
expect over the potential infinite
life of the equity security
• Theory tells us that a weighted
average of all debt risk is a
function of the asset risk on the
left-hand side of the balance sheet
• But it is a matter of debate
whether one should further sort
debt risk by matching debt
maturity to the length of the
project
• While picking a debt instrument
Discussion Question

Should you calculate a weighted average of all

debt or a weighted average of long-term debt
with maturities that match the length of the
project?
Estimating WACC
• Tax rate • This appears to be an economically unattractive
• The theory requires an analyst to use the project
marginal, expected tax rate • The only way to establish a level of confidence
• Some students may use historical, average tax with this conclusion is to test WACC’s sensitivity
rates (which they derive by dividing annual tax to variations in the underlying assumptions
expense by pretax profits) • Range of WACC estimates consistent with various
• As the case notes, Boeing’s tax exposure has assumptions that the instructor might encounter
been lower in the past than it is expected to be in • The revelation is that the vast majority of the
the future; using the marginal effective tax rate of estimates are smaller than 15.7%
35% is, therefore, more appropriate. • A key difference has to do with the term of the
• Capital-structure weights beta used in the estimate
• The theory requires an analyst to use market • The 60-day beta, for example, gives heavy weight
value, not book value, weights to the Iraq war and SARS
• Case Exhibit 10 provides the market value • If you believe that SARS and war will have an
debt/equity ratio for Boeing as 0.525 From this, ongoing and significant risk to the commercial-
you can derive the percentage debt and equity to aircraft industry, then this should be your beta of
be 34.4% and 65.6% respectively choice
• The WACC estimate • Conversely, you could argue that the 21-month
• With all the assumptions given in this illustration, beta (beginning September 2001) places more
the base-case estimate of the WACC to be 16.7%, weight on the broader history of two wars
greater than the base-case IRR scenario of 15.7% (Afghanistan and Iraq) and the general risk of
terrorism
• The 60- month beta dilutes impact of terrorism,
war, and SARS risk
Estimating WACC
• Need for a “view” • In short, methods that focus on the
• Plainly, the practitioner needs to have a time value of determinate cash flows
view about political and economic do not capture contingent cash flows,
fundamentals in the future and by its very focus on the “project,”
the forecast of cash flows may ignore
• History is one guide to what might other economic benefits outside of the
happen in the future 7E7 project, or in the realm of
• Only 12 years earlier, Boeing intangible value
committed to build the 777 aircraft in • The wise analyst understands that DCF
the face of a similar economic and likely tells only part of the story
political environment
• The wise board of directors will
• Though history is never a perfect guide, ruminate over the range of effects that
it lends more insight than random DCF might miss
guesses or agnosticism
• These other factors might compel a
• In the final analysis, the numerical board to approve a project whose IRR
analysis is not enough; it must be did not exceed its WACC, or
supported by some kind of outlook alternatively, to reject a project when
• The Problem for the Board of the IRR did exceed the WACC
Directors
• This phase of the discussion, in effect,
shifts in order to reflect on the
Discussion Question
Have we thought of everything? Is there anything
else the board of directors should consider in
assessing the financial appeal of this project?

Why might the board vote “yes” on the 7E7 when

the cost of capital estimate is greater than the IRR?

Why might the board vote “no” if the cost of capital

estimate is less than the IRR?
Strategic Options
• Perhaps this project creates rights or • If it ever tried to re-emerge as a
options; perhaps not undertaking this commercial aircraft industry leader,
project would limit or shorten would it have that ability?
Boeing’s strategic flexibility elsewhere
in the industr
• Airbus has already overtaken Boeing
in this industry by many measures,
and, perhaps without the 7E7, Boeing
would essentially relinquish
permanent and dominant control of
this industry
Growth and R&D Options
• Rights to grow in new markets are
valuable options: arguably, the 7E7
positions Boeing favorably with
opportunities to grow in the regional
jet market
• Technological spin- offs, from the 7E7
project to other projects at Boeing,
create technology options for the
company— innovations in the use of
composite materials and fuel-saving
designs can position Boeing to
compete more effectively against
Airbus
Related Activities in Other Divisions
• The new product line will augment Boeing’s after market • Ultimately, Boeing is in the business of building airplanes
parts and service business • No doubt, the board and senior management will feel a
• Unclear from the forecast is the extent to which this strong impulse to approve the 7E7 project, as a statement
activity is captured in the 7E7 projections—but even if it about Boeing’s commitment to the commercial airplane
is, perhaps there are scale economies in parts and service business
that the 7E7 will help other divisions of Boeing exploit • The mission of the firm is an extremely important
• The board should also scrutinize opportunities for consideration in the review of a project such as this
effective risk management through operations that could • But the financial staff must lend some discipline in pursuit
reduce Boeing’s exposure on this project of the mission
• For instance, case Exhibit 9 shows that the IRR is very • The 7E7 project is certainly not the only new airframe
sensitive to both development and production costs opportunity facing Boeing
• If the percentage of COGS/sales goes from 80% (base • Project analysis needs to establish the attractiveness of
case) to 84%, then the IRR plummets from 15.7% to this project at this time
10.3%
• In the end, the board would probably be reluctant to
• This sensitivity suggests that innovations in concede an attractive market segment to competitors,
manufacturing processes, purchasing, and assembly but would impose risk management conditions that
might have a very large beneficial impact on the would protect the firm
profitability of the project—if they pay • This is how the board proceeded
• Another form of risk management by the board would be
to establish milestones at which progress on the project
would be reviewed and changes made, if necessary
• Tailoring managerial incentive systems to keep within the
financial parameters is another form of risk management
• Examples of techniques that can limit Boeing’s downside
on the 7E7.
Epilogue
• In an unprecedented and highly risky • Boeing, therefore, was now
move, in September 2003, the board considering three versions of the 7E7
voted to take orders for the 7E7 on a to accommodate the Asian market and
limited basis the markets outside Asia
• Specifically the board provided • Multiple models, however, typically
permission to offer the 7E7 to Japan’s drive up development costs, and the
two largest airlines: All Nippon Airways board had already stated that it would
and Japan Air Lines not back the 7E7 unless development
• It was considered particularly risky, costs were lower than what it took to
however, to launch the 7E7 without a develop the 777
major U.S. customer • In December 2003, the board
• For example, when Boeing developed unanimously voted to give its sales
the 777, it worked closely with its U.S. force the authority to offer the 7E7
customers, who in turn had significant worldwide
influence on the plane’s design • Missing from this announcement,
• While the Asian market was forecasted however, was any airline that had
to be the largest growth market, the agreed to buy the plane so early in the
needs of the Japanese were short process
range, while the needs of the rest of
the world were longer range
• Background Comments on the Equity Market Risk Premium
• The theory of capital asset pricing gives no guidance on its practical application. Finance theory says the equity market
risk premium should equal the excess return expected by investors on the market portfolio relative to riskless assets.
How one measures expected future returns on the market portfolio and on riskless assets are problems left to
practitioners. A survey of “best practice” financial offices, by Bruner, Eades, Harris, and Higgins1, on the estimation of
the cost of capital, found that practitioners disagree most sharply on the question of the measurement of the equity
market risk premium. Scholars, too, offer a wide range of views, as summarized in a roundtable discussion by Ivo
Welch.2 Because expected future returns are unobservable, “best practice” is to extrapolate historical returns into the
future on the presumption that past experience heavily conditions future expectations. Where practitioners differ is in
two dimensions:
•   use of arithmetic versus geometric average historical equity returns
•   choice of realized returns on T-bills versus T-bonds to proxy for the return on riskless assets.
• The arithmetic mean return is the simple average of past returns. Assuming that the distribution of returns is stable
over time and that periodic returns are independent of one another, the arithmetic return is the best estimator of
expected return.3 The geometric mean return is the IRR between a single outlay and one or more future receipts. It
measures the compound rate of return investors earned over past periods and accurately portrays historical investment
experience. Unless returns are the same each time period, the geometric average will always be less than the
arithmetic average and the gap widens as returns become more volatile.4
• The standard source for measured equity market risk premiums is Stocks, Bonds, Bills, and Inflation, an annual
yearbook published by Ibbotson Associates. As noted on page two of this teaching note, Ibbotson’s estimates of EMRP
from 1926 to 2003, offer a relatively wide range of values, depending on use of the geometric as opposed to the
arithmetic mean equity return and on use of realized returns on T-bills as opposed to T-bonds.
• Even wider variations in market risk premiums can arise when one changes the historical period for averaging.
Extending U.S. stock experience back to 1802, Siegel5 shows that historical market premia have changed over time and
were typically lower in the pre-1926 period. Visual inspection of the Ibbotson estimates shows considerable variation in
historical premia over different time periods and methods of calculation, even with data since 1926.
• Robert F. Bruner, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins, “‘Best
Practices’ in Estimating the Cost of Capital: Survey and Synthesis,” Financial
Practice and Education (Spring/Summer 1998).
• 2 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=234713.
• 3 Several studies have documented significant negative autocorrelation in returns
—this violates one of the essential tenets of the arithmetic calculation, since if
returns are not serially independent, the simple arithmetic mean of a distribution
will not be its expected value. The autocorrelation findings are reported by: Fama
and French (1986), Lo and MacKinlay (1988), and Poterba and Summers (1988).
• 4 For large samples of returns, the geometric average can be approximated as the
arithmetic average minus one-half the variance of realized returns. Ignoring
sample size adjustments, the variance of returns in the current example is 0.09
yielding an estimate of 0.10 − 2(0.09) = 0.055 = 5.5% versus the actual 5.8%
figure. Kritzman (1994) provides an interesting comparison of the two types of
averages.
• 5 Jeremy J. Siegel, “The Equity Premium: Stock and Bond Returns Since 1802,”
Financial Analysts Journal 48, 1 (January/February 1992): 28–46.
• The survey by Bruner et alia found that a majority of texts and trade books support use of the arithmetic mean
return over T-bills as the best surrogate for the equity market risk premium. Half of the financial advisors
queried use a premium consistent with the arithmetic mean and T-bill returns, and many specifically
mentioned use of the arithmetic mean. Corporate respondents, on the other hand, evidenced more diversity
of opinion and tend to favor a lower market premium of about 6%.
• This variety of practice should not come as a surprise since theory calls for a forward-looking risk premium, one
that reflects current market sentiment and may change with market conditions. What is clear is that there is
substantial variation as practitioners try to operationalize the theoretical call for a market risk premium.
• As a practical matter, the best practice in the estimation of WACC is to adopt a “house view.” This view is driven
by values and beliefs about markets and analysis. For instance, the analyst could consider these points:
•   We do not calculate the cost of capital, we estimate it. This means that any WACC should be viewed as
having a range of uncertainty surrounding it. We cannot eliminate the uncertainty; but best practice should aim
to narrow the range. Uncertainty about EMRP is one source of uncertainty in our estimates of WACC. One
response is to embrace this uncertainty in the analysis of projects, mainly by conducting sensitivity analysis of
IRRs and NPVs, as driven by the range of WACCs.
•   The choice of T-bills or T-bonds as the basis for EMRP depends on one’s view about the best way to impound
inflation expectations in project analysis. Treasury instruments capture inflation expectations prevailing for the
life of the instrument. A common practical response is to use a Treasury instrument that is contemporaneous
with the life of the asset being valued. The Boeing 7E7 is a long-lived project and, therefore, could be gauged
against the T-bond-based EMRP.
•   The choice of geometric versus arithmetic is simply irresolvable. Both methods have desirable attributes and
weaknesses. Here, thoughtful practitioners choose a method of calculation that yields results that seem
reasonable.
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