Boeing 777 Project
... table. All of the following statistics were given with the exception of the Beta. Our discussion of our determination of Beta follows: Boeing’s beta 1.20 Boeing’s market-value debt ratio 1.79% Boeing’s new issue rate for long-term debt 9.75% Riskless return (T-bond rates in 1987) 8.82% Market risk premium 5.4% Boeing’s marginal income tax rate 34% Several Betas were given in the case study, and calculated over a 4 year period. They ranged from .81 over 58 months to 1.79 over 2 months. We felt that a premium must be added to the lower Beta to factor in the turmoil in the industry at the time and the vast expense of this project. Also, analysts had correctly, we feel, pointed out that the defense portion of Boeing was more stable and thriving in the midst of the Gulf War crises. Boeing derived about 25% of its revenues from the U.S. defense and space programs and the remainder from its commercial aircraft business. During 1987 to 1989, Boeing derived about 87% of its operating profit from commercial aviation. In determining an appropriate beta for the CAPM calculation, the beta of a pure play firm engaged in commercial aviation should be used. Airbus, a primarily commercial aviation manufacturer, did not have an available beta for comparison. Therefore we will estimate that the beta for the commercial aircraft business is 2.0. Given these assumptions the CAPM may be employed to find Boeing’s commercial aviation division’s levered cost of equity capital (Rs) at Boeing’s current debt ratio. Rs=Rf+B(Rm-Rf) Rs=.0882 + 2.0 (.054) = 19.62% The capital budgeting analysis will be done based on three scenarios: (1) Boeing maintains its current leverage ratio, (2) Boeing is purely equity financed, and (3) Boeing increases its leverage. BOEING MAINTAINS ITS CURRENT LEVERAGE RATIO At the current debt to equity ratio, the WACC can be determined as follows: WACC=(D/V)*Rd*(1-Tc) + Rs*(S/V) WACC=(271/15,149)*.0975*(1-.34) + .1962*(14,878/15,149) WACC=19.39% The amount of long term debt is stated on Note 1 of Boeing’s 1988 Balance Sheet ($271). The market value of Boeing’s equity is calculated based on its 346 million shares outstanding at $43 per share ($14,878). The total value of the firm is the sum of the market value of debt and the market value of equity ($15,149). Based on a WACC of 19.39%, the NPV of the project is negative and the discount rate is greater than the project’s internal rate of return. The project should be rejected. BOEING IS PURELY EQUITY FINANCED We can calculate the unlevered firm’s cost of equity as: Rs=R0+B/S (1-Tc)(r0-rb) .1962= R0+ 271/14878 (1-.34)( R0 – .0975) R0 = 19.50% The unlevered cost of equity capital is less than the levered cost of equity capital since the decrease in debt financing lessened the risk to equity holders. As should be expected, the NPV of the project discounted at Boeing’s purely equity cost of capital is lower than the NPV of the project discounted at Boeing’s weighted average cost of capital with some leverage. The project should still be discounted since the NPV of the project is negative and the discount rate is higher than the project’s internal rate of return. BOEING INCREASES ITS LEVERAGE Assuming that the project is financed 20% by debt and 80% by equity, the following steps are taken: Determine the cost of levered equity at the new leverage ratio: Rs=Ro+B/S*(1-Tc)*(Ro-Rb) Rs=.1950+2/8*(1-.34)*(.1950-.0975) Rs=21.11% The cost of levered capital is greate...