Introduction
The idea of implementing the new type of Boeing airplane by the Boeing Commercial Airplanes Company was rather controversial when it was expressed in 2003 (Bruner, 2008, p. 233; Smith, 2003, p. 42). On the one hand, the officials from the Boeing Company and the market analysts all claimed that the introduction of the Dreamliner Boeing 7E7 was a smart step drawing from the immense market demand for airplanes of the type (Bruner, 2008, p. 241). On the other hand, there were no guarantees that the project would succeed and bring the Boeing Commercial Airplanes Company an acceptable and intended profit (Bruner, 2008, p. 251). To understand this, Boeing needed the analysis of its internal rates of return (IRR) and the comprehensive picture of the weighted-average cost of capital (WACC) involved in the Boeing 7E7 project.
Required and Internal Rates of Return; Weighted-Average Cost of Capital (WACC)
Capital Asset Pricing Model and Cost of Equity
The process of estimating the weighted-average cost of capital (WACC) for Boeing’s commercial-aircraft business segment to evaluate the IRRs involves also the procedure of determining the appropriate required rate of return against which the prospective IRRs from the Boeing 7E7 can be evaluated (Pritchard and MacPherson, 2004, pp. 57 – 58; Simkins, 2009, pp. 6 – 7). Consequently, the cost of equity for Boeing should be estimated using the capital asset pricing model (CAPM) (Wang, 2003, p. 28). The formula that allows calculating the cost of the company’s equity is as follows:
Ke = Krf + b (Km – Krf),
where Ke is the cost of equity (also referred to as We), Krf is the risk-free rate, b is the company’s beta coefficient, while the Km is the return of the market which is available from the case study and the Boeing Company projections about the market return rates of the Boeing 7E7 project (15.66%) (Bruner, 2008, p. 235).
Accordingly, having the data about the market position of the Boeing Company, its risk-free rates (3.88%), return of the market (15.66%), and beta coefficient (1.26%), it is now possible to determine the company’s cost of equity (The Boeing Company, 2009):
Ke = Krf + b (Km – Krf)
Ke = 3.88 + 1.26 (15.66 – 3.88)
Ke = 3.88 + 1.26 (11.78)
Ke = 3.88 + 14.843
Ke = 18.72%
For the above calculations, the data about the beta coefficient and the risk-free rates were used that are traditionally used in such situations. The beta coefficient of the Boeing Company is observable among its financials in the annual financial reports of the company, while the risk-free rates are traditionally taken from the US treasury yields that are calculated for the recent 10 years and are available from the website of the US Treasury (Pritchard and MacPherson, 2004, pp. 57 – 58).
Equity Market Risk Premium (EMRP) and Risk-Free Rate
While using the capital asset pricing model (CAPM) to calculate the cost of equity for the Boeing Company, the implementation of the risk premium (EMPR) becomes necessary (Johnson and Soenen, 2009, p. 14). To calculate the risk premium, two major ways are used. The first way is to address reputable financial resources like Google Finance or the official website of the United States Treasury and retrieve the information about the 74-year equity market risk premium (EMPR) from there. According to this method, the 74-year equity market risk premium for the United States is at the average level of 11% (The Boeing Company, 2009).
However, for more precise data, it is necessary to address the formula of the market risk premium and derive the specific meaning for this risk premium from the observable data on Boeing Company (Bruner, 2008, p. 242). Namely, this method was used during the calculation of the cost of equity of the Boeing Company through the capital asset pricing model (CAPM). According to the formula, the market risk premium (EMPR) is calculated by the way of subtracting the risk-free rates (Rf) multiplied by the company’s beta (b) coefficient from the expected market return meaning (ERm) (Johnson and Soenen, 2009, p. 14).
Having the data that the beta coefficient for Boeing Company is 1.26%, the applicable risk-free rate is 3.88%, and the expected market return from the Boeing 7E7 project is 15.66%, the market risk premium can be calculated as follows (The Boeing Company, 2009):
EMPR = ERm – (Rf * b)
EMPR = 15.66 – (3.88 * 1.26)
EMPR = 15.66 – 4.89
EMPR = 10.77
Capital-Structure Weights i.e. Debt and Preferred Stock Weights
Finally, coming closer to the estimation of the weighted-average cost of capital (WACC) involved in the Boeing 7E7 project it is necessary to consider the use of the capital structure weights, i. e. the weights of debt and common stock. These components are so important as the formula for calculating the weighted-average cost of capital (WACC) consists of three elements that are the weight of the debt (Wd), the weight of equity (We), and the weight of the common stock (Wcs), which are all synonymous to the concepts of the cost of debt, cost of equity, and the cost of common stock (Pritchard and MacPherson, 2004, p. 12):
WACC = Wd + We + Wcs
Since the cost, or weight, of equity, has been calculated above, the weights of debt and preferred stock need to be considered now. Thus, the weight of debt in the total volume of the Boeing Company equals 17.9% as estimated for 2003. The important point in this calculation is that the debt should be estimated without taxes. Accordingly, the effective tax rate (Tr) of 35% should also be applied to the formula of the weight of debt calculation after taxes (What) (Bruner, 2008, p. 27; The Boeing Company, 2009):
Wdat = Wd (1 – Tr)
Wdat = 17.9 (1 – 0.35)
Wdat = 17.9 (0.65)
Wdat = 11.64%
Further on, the common stock weight is calculated using the formula dividing the common stock dividend (Dcs) by the market price of the common stock (Pcs). The common stock market price for Boeing Company equals $5.061,000, while the dividend on common stock reaches the level of $1.192,000 (The Boeing Company, 2009). Accordingly, the weight of the common stock for the company is:
Wcs = Dcs / Pcs
Wcs = 1.192 / 5.061
Wcs = 23.6%
Thus, after all the capital structure weights are calculated, it is necessary to put the formula of WACC together. Here, it is important to notice that the capital structure of the Boeing Company consists of 40% debt, 50% of equity, and 10% common stock. Drawing from this, the WACC formula will look as follows (The Boeing Company, 2009):
WACC = 0.4 (Wd)+ 0.5 (We)+ 0.1(Wcs)
WACC = 0.4 (11.64)+ 0.5 (18.72)+ 0.1(23.6)
WACC = 4.7 + 9.4+ 2.4
WACC = 16.5%
Accordingly, the weighted-average cost of capital (WACC) for the commercial segment of the Boeing Company equals 16.5%, which is more than the internal return rates (IRR) forecasted for the project in case if it is implemented.
Project Attractiveness based on WACC
Circumstances of Economic Attractiveness
Thus, the above considerations and calculations allow speaking of the Boeing Company’s weighted-average cost of capital being larger than the internal return rates forecasted for the Boeing 7E7 project, which is a dangerous fact in the light of the basic principles of the economic theory. According to the latter, any project needs to be assessed in regards to the internal return rates (IRR) it has presented or forecasted and the weighted-average cost of capital (WACC) of the company or for its segment involved in the project. In case if the IRR exceeds the WACC figure, the project is traditionally considered to be potentially beneficial and favorable for further development (Lin, 2005, pp. 21 – 22). On the contrary, when the WACC figure, as in the Boeing case, is greater than the IRR meaning the project is strongly recommended for rejection. Therefore, the Boeing 7E7 project displays no signs of economic attractiveness.
Project Sensitivity Analysis and Boeing Gamble
On the other hand, the sensitivity analysis of the case might provide somewhat different results (Pannel, 2009). In more detail, the estimated IRR and the WACC are only the forecasted and assumed figures that have only financial projections as their grounds. Therefore, the meanings of the IRR and WACC, especially, might be changed in case if an element of their composition develops in a different direction (Pannel, 2009). For example, if the Boeing Company experiences the reduction of its debt at least 1.5% to 2%, the total WACC meaning might be reduced as well to the necessary point so that the IRR should exceed WACC.
As well, the Boeing Company might resort to reducing the common stock dividends payments and achieve the reduction of the weight of the common stock in its capital structure, which would also provide for the necessary IRR and WACC relation for the project to be considered acceptable. In any case, relying upon the projections and sensitivity analysis is a major gamble for Boeing. Should any of the considered factors develop not the way it is projected, the success of the project will be endangered, and so will be the financial stability of the company.
Final Statements on Project Approval Decision
Thus, drawing from the above-presented calculations and theoretical considerations it is not recommended for the Boeing Company Board to approve the Boeing 7E7 project under the currently projected figures of IRR and weighted-average cost of capital (WACC) of the company. The reason for such a recommendation is the precaution of the economic theory according to which a project, whose estimated IRR is lower than the company’s WACC is potentially unprofitable and detrimental. However, the Boeing Company might attempt the project implementation provided it reduces some of the WACC components and adjusts the WACC meaning to the level below the IRR so that the project could be theoretically successful in projections.
Reference List
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Lin, J. (2005). What’s New About Outsourcing? Pacific Asia Free Trade and Development 30th Conference, 1 – 25.
Pannel, D. (2009). Sensitivity Analysis. Crawley. [online] University of Western Australia. Web.
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Pritchard, D. and MacPherson, A. (2005). Boeing’s Diffusion of Commercial Aircraft Design and Manufacturing Technology to Japan: Surrendering the US Aircraft Industry for Foreign Financial Support. Canada – United States Trade Center Occasional Paper, 30, 1 – 14.
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