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= ?_EC*(R_M-R_f )+R_f where REC is the cost of equity capital of the commercial aircraft division. ?EC 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: ?_U= ?W_D*??_UD+?W_C*??_UC where ?U is the unlevered beta of Boeing as a whole company. ?UD is the unlevered beta of the defense aircraft division derived from other comparable firms. ?UC 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 ?UC. ?UD of Boeing defense division is approximated by using the 5-year ?U 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 use their arithmetic mean of firm unlevered betas as a proxy for the unlevered beta of Boeing’s defense department, which equals to 0. 4840. WD and WC are approximated according to the percentage of revenues of Boeing on defense and commercial section, which is 46% and 54% respectively.
Therefore, the ?UC is equal to 1. 0374. Furthermore, using the formula below, the equity beta of the commercial division is estimated to be 1. 3914. Since the market-value debt to equity ratios for the commercial division is not given nor specified, we simply assume the D/E ratio of it equals to the D/E ratio of the whole company Boeing, 0. 525. ?_EC= ?_UC*(1+D/E*(1-Tax Rate)) Hence, the cost of equity is projected as: 1. 3914*7. 59%+4. 56%=15. 12% Given the 30-year outstanding bond yield (2033) of the Boeing Company as 5. 5%, we will then have the necessary information to estimate the WACC for project evaluation. WACC= 0. 525/(0. 525+1)*5. 85%*(1-35%)+1/(0. 525+1)*15. 12%=11. 22% A sensitivity analysis of WACC has been done on market rate of return against equity beta as well as market value D/E ratio solely. As shown in Table 3, WACC is very sensitive to changes in both market rate of return and equity beta.
The sensitivity of WACC against ?EC increases when Rm is at a higher level. In Table 4, it shows that the changing effect of D/E ratio on the WACC is not so material when compared with the projected 15. % IRR. Project Evaluation The project would be economically attractive if Boeing can achieve the goal of selling volume and price in the next 20 years. Also, if Boeing can achieve its 7E7’s objective as forecasted, less fuel, cheaper operating costs, and long or short distance flexibility, then, it helps Boeing completing with its largest competitor, Airbus, to turn around the existing worse company position in the commercial aircraft industry. Market Demand Since the September 11 attacks, passengers lost the confidence for the U. S. ommercial aircrafts. The declining airplane orders as a result leads to a number of potential replacement of mid-range aging planes. Customers are now in search of planes which are of lower operating costs, and 7E7 will be a good choice to satisfy those needs. In addition, the downturn of business cycle and advance in video-conferencing technologies also affect the company estimation of future demand. It predicts that during the next 20 years, economies will grow annually by 3. 2%, and air travel will grow with GDP at an annual rate of 5. 1%.
According to this long-term market outlook, it suggests that there will certain be a market for 7E7. Market Share Airbus will launch their new large, long distance plane A380 in 2006. This plane can be a dreadful competitive product to Boeing. If Boeing falls behind regarding innovations, fuel efficiency and other attributes of a long haul airliner, it will soon lose its market share. In order for Boeing to compete in the aviation industry, it is crucial to take on some risk and develop this new 7E7 project. This helps the company to fight against its competitors and recover from the slump in the industry.
Financial Analysis The sensitivity analysis on IRR provided by the case in Exhibit 9 is demonstrated in Table 3 in Appendix. With reference to the calculated WACC, 11. 22%, most of the circumstances considered in the sensitivity analysis suggest the acceptance of the 7E7 project. However, if the air travel demand worsened and sold only 1500 in the first 20 years, the project will be abandoned even if there is a 5% premium in price. If the unit volume sold is equal to or above 1750 airliners, then the IRR will always greater than 11. 21% even if there is no price premium.
Another view focuses on changes in costs. As long as Boeing can maintain the target COGS/Sales ratio to be 80%, then the IRRs will all be favorable between the forecasted development cost ranges $6 to $10 million. However, if COGS is out of control and rises up to 84% of Sales, then acceptance of the project will cause a loss in cases that development cost is above $7 million. When development cost is at the level of $10 million, the project should not be accepted if COGS at or above 82% of Sales. Recommandations On balance, we highly recommend that Boeing should accept the 7E7 project.
The major reason is because according to our projected WACC, 11. 22%, the project IRR 15. 7% exceeds it by 4. 48%, given the targets of 2500 units sold, 5% price premium, $8 million development cost and 80% COGS/Sales. Even if the company is not on target, there will still be rooms allowing for some unfavorable changes. Strategically speaking, this 7E7 helps the company to track the expected economic growth in the following years and acts as a competitive tool against Boeing’s major competitor in the commercial aircraft industry, Airbus. As a conclusion, it will be beneficial to Boeing if 7E7 project is approved.