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Case #16 The Boeing 7E7 Synopsis and Objectives In 2003, the Boeing Company announced plans to build

a new super-efficient commercial jet called the 7E7 or Dreamliner. This was a bet the farm gamble by Boeing, similar in magnitude to its earlier introductions of the 747 and 777 airliners. The technological superiority of the new airframe, as well as the fact that it would penetrate a rapidly growing market segment, were arguments for approval of the project. On the other hand, the current market for commercial airplanes was depressed because of terrorism risks, war, and SARS, a contagious illness that resulted in global travel warnings. Boeings board of directors would need to weigh those considerations before granting final approval to proceed with the project. The task is to evaluate the 7E7 project against a financial standard, the investors required returns. The case gives internal rates of return (IRR) for the 7E7 project under base-case and alternative forecasts. We must estimate a weighted-average cost of capital (WACC) for Boeings commercial-aircraft business segment in order to evaluate the IRRs. As a result of that analysis, we will identify the key value drivers and distinguish, on a qualitative basis, the key gambles that Boeing is making. The need to estimate a segment WACC draws out our abilities to critique different estimates of beta and to manipulate the levered-beta formulas. Boeing competes in both the commercial aircraft and the defense business. Thus, deriving the appropriate benchmark WACC for the 7E7 project requires isolating the commercial aircraft component from Boeings overall corporate WACC. Suggested Questions 1. What is an appropriate required rate of return against which to evaluate the prospective IRRs from the Boeing 7E7? a. Please use the capital asset pricing model to estimate the cost of equity. At the date of the case, the 74-year equity market risk premium (EMRP) was estimated to be ___. Which beta and risk-free rate did you use? Why? b. When you used the capital asset pricing model, which risk-premium and risk-free rate did you use? Why? c. Which capital-structure weights did you use? Why? 2. Judged against your WACC, how attractive is the Boeing 7E7 project? a. Under what circumstances is the project economically attractive? b. What does sensitivity analysis (your own and/or that shown in the case) reveal about the nature of Boeings gamble on the 7E7?

3. Should the board approve the 7E7?

Exhibit TN1 Boeings Commercial Beta (1)

Boeings Commercial Beta

Commercial Beta Boeing Assets Step 2 Defense Beta

Debt Beta Step 1 Equity Beta UnleveredBeta

Exhibit TN2 Unlevered Beta Derivation Unlevered Beta Derivation

VU tcD D E The value of a firm with debt can be thought of as the sum of the market value of its debt (D) and equity (E) or the sum of its value as if unlevered (VU) plus the benefit of the corporate debt tax shield (tcD).

A weighted average of the debt and equity betas on the right hand side must equal a weighted average of betas on the left hand side. Assuming riskless debt yields the following formula:

(1 - t c ) D L = 1 + U E

Exhibit TN3 Sample Illustration: Sample Illustration: Boeings Unlevered Beta Boeings Unlevered Beta
(1 - t c ) D L = 1 + U E (1 - t c ) D Or U = L 1 + E

Inputs from Case Exhibit 10: Tax rate (tc)= 0.35 Market value debt/equity ratio = 0.525 60-day NYSE equity beta (L) = 1.62 Result: Unlevered beta (U) = Boeings asset beta = 1.21

Exhibit TN4 Boeings Commercial Beta

Boeings Commercial Beta

Boeings commercial beta Boeings asset beta: 1.21 Boeings defense beta 1.21 = (% defense)(defense) + (% commercial)(commercial)

Exhibit TN5 Example: Unlevered Example: UnleveredDefense Beta of 0.25 Defense Beta of 0.25
Inputs From Case Exhibit 10 Lockheed Martin 0.37 0.35 0.41 0.29 Northrup Grumman 0.30 0.35 0.64 0.21

60-day NYSE equity beta (L) Tax Rate (tc) Debt/equity

Unlevered Beta Result Average: 0.25

Exhibit TN8 Example: Commercial Cost of Cost Example: Commercial Equity of Equity
Unlevered commercial = 2.03 The relevered commercial = 2.72
commercial equity commercial ( rm - rf ) = 0.237 = 23.7% = r f + equity


Using the 3-month t-bill rate of 0.85% and 8.4% equity-market risk premium yields a commercial cost of equity of 23.7%.

Exhibit TN11 Example: WACC Estimate for Commercial Segment Example: WACC Estimate for Commercial Segment WACC = (% Debt)(rd)(1-tc) + (% Equity)(re) Inputs: % Debt = 34.4% % Equity = 65.6% tc = 35% re = 23.7% rd = 5.33%

commercial equity

commercial = r f + equity

(r - r )
m f

Major re Assumptions: Commercial and defense weights proxied by % revenues Use of 60-day NYSE beta

WACC = (0.344)(0.053)(1-0.35) + (0.656)(0.237) = 0.167 = 16.7%