1926 words - 8 pages

Corporate Finance Group E4

The Boeing 777

1. Boeing consists of two separate businesses, the defense business which is considered to the more stable since it does not depend on the actual condition of the economy, and the commercial-aircraft business which is more volatile and correlates strongly with the state of the economy. Since we are trying to evaluate the viability of the Boeing 777 project, we are going to estimate de required rate of return incorporating only the risk associated with the commercial-aircraft business and exclude any effect the defense business can have on our calculations. To incorporate the risk factor of this business in the required rate of return calculation, ...view middle of the document...

Finally we have estimated that Boeing’s Beta for the Boeing 777 project is 1.11. This number makes sense since the commercial-aircrafts business is more risky than the overall risk of the company, which includes the more stable and less risky defense business. In addition, taking more debt will also increase the project overall risk. Exhibit 1 summarizes the calculations. 2. To calculate the appropriate required rate of return we have used the CAPM model. The inputs needed for this model are the risk-free rate, the market risk premium and the Beta of the project, which we have already calculated. There are several approaches to calculate the market risk premium using historical data. When reliable long-term records of equity returns are available, historical estimates have been a familiar and popular choice of estimation. “If investors do not make systematic errors in forming expectations, then, over the long term, average returns should be an unbiased estimate of what investors expected”1. There are two

1

CFA Program Curriculum, Volume 4 2011, Page 110, CFA Institute.

1

Corporate Finance Group E4 choices for computing the mean of market returns and two broad choices for the proxy for the risk-free return: long-term government bond returns and short-term government debt instruments (Treasury bill) returns. The CAPM model is a single-period model, so the arithmetic mean seems to be a more consistent choice. Nevertheless the geometric mean return of a sample represents the compound rate of growth. “Equity risk premium estimates based on the geometric mean have tended to be closer to supply-side and demand-side estimates from economic theory than arithmetic mean estimates”2. For this reason we prefer to use the geometric mean. Industry practice has also tended to favor use of a long-term government bond rate in premium estimates. “A risk premium based on a bill rate may produce a better estimate of the required rate of return for discounting a one-year-ahead cash flow, but a premium relative to bonds should produce a more plausible required return/discount rate in a multi-period context of valuation”3.For this reason we use the longterm Treasury bonds in our calculation since Boeing’s 777 project has a multi-decade life spam. The market risk premium we have used is 5.6%. Risk-free assets usually refer to short-dated government bonds but to be consistent with our market risk premium calculation we have also considered the rate on long-term government bonds to be the risk-free rate in our require rate of return calculation. This long-term rate is more relevant when discounting cash flows that go well into the future like in Boeing’ case. 3. Analysts were predicting that Boeing would increase the debt ratio to 14 percent over the next years because of future financial needs. Because the company’s capital structure is going to change over time, WACC may also change over time. For this reason we are going to use a target weight instead of the...

Beat writer's block and start your paper with the best examples