Boeing 777 Case Study
Question 1 - What is the appropriate required rate of return against which to evaluate perspective IRR from Boeing 777?
To evaluate the IRR of Boeing 777, need to compare it against the WACC of Boeing’s commercial business. The first step is to estimate a value for WACC:
1. Cost of Debt
As provided in the case, the tax is 34%, and the cost of debt is 9.73% - derived from the yield to maturity of Boeing-issued debt with a 5-year maturity. As such, the after tax Boeing cost of debt is estimated to be 6.42%.
2. Cost of Equity
To calculate the cost of equity, we ...view middle of the document...
As the S&P 500 is an index representative of the large cap universe, we chose to look at the 58-months S&P 500 beta figures.
To calculate the beta of Boeing’s commercial business, we took out the defence beta by looking at unlevered beta (beta asset) of companies with high defence contribution (or defence pure plays) which are Grumman, Northop and Lockheed.
First, we calculated the beta of debt (assumed equal for all companies, given they have the same risk, and hence it is safe to assume they have similar cost of debt):
βdebt = (9.73% - 8.82%) / 5.4% = 0.169
The table below summarizes the calculations, assuming beta debt of 0.169:
| Boeing | Grumman | Northop | Lockheed | McDonnell | Average |
% US Space | 26% | 87% | 89% | 85% | 66% | |
Beta Equity | 0.81 | 0.8 | 0.74 | 0.87 | 0.6 | 0.803 |
Beta Debt | 0.169 | 0.169 | 0.169 | 0.169 | 0.169 | |
Debt/Equity | 0.018 | 1.756 | 1.288 | 1.182 | 2.714 | |
Beta Asset | 0.799 | 0.398 | 0.418 | 0.490 | 0.285 | 0.435 |
| Defence Pure Players | | Commercial/Defence Players |
We can now assume that Boeing Defence unlevered beta is 0.435. We need to take out the Boeing Defence beta from the total Boeing Beta to get the commercial beta.
We are provided with both revenue and asset splits. Because assets provide a historic view of the company, and the commercial sector has been growing fast within Boeing, it makes more sense to look at the revenues split. This split is also a good approximation of Boeing’s target divisional split, which is important in valuing different divisions of a business.
| Total Boeing | Defence | | Commercial |
Revenue Split | 100% | 26% | | 74% |
Unlevered Beta | 0.799 | 0.435 | | 0.93 |
The last step is to re-lever the beta and calculate Boeing’s commercial equity beta. Using the same debt-to-equity ratio of 0.018, the equity beta of Boeing commercial is 0.94.
3. Weight of Debt and Equity
We used the market value capital structure of Boeing – 1.8% debt and 98.2% equity (rationale provided in Question 3). We use gross debt instead of net debt, both of which are possible, as long as it is applied consistently in the model.
We now established all the components of the WACC and can apply the initial formula with which results in a WACC of 13.76%.
Question 2 – What is the value of the market risk premium that you have used? To what extent would you use historical excess returns? Explain also the choice of the risk free rate.
Geometric means are more useful for long-term investments. Serial correlation between returns of a specific period will push the arithmetic mean upward which is not an accurate indication of future performance. However, the preference of one over another is a source of academic debate; both have flaws, a blend of the two is optimal, but not available.
Given that we selected a long-term risk-free rate we need to use a measure of long-term market risk to be...