The Boeing 7e7 Project: Cost of Capital

The Boeing 7E7 Project: Cost of Capital

Team Members: Shuang Lin, Zhen Huang, Jinshu Ma

1. Analysis Conclusion Overview

We estimate the cost of capital for Boeing 7E7 project to be 7.8%, lower than the IRR in the base scenario, which is 15.7%. It shows that this project is quite lucrative. On the other hand, our scenario analysis shows that 7E7 project comes with a very volatile IRR, but only in an extreme scenario could IRR be lower than cost of capital. Combined this analysis with our other considerations, we make the final decision that although Boeing 7E7 project is both economically and strategically feasible.

1. Macro Economy and Industry Analysis

In 2002, The United States started a war with Iraq, global terrorism problems were aggravated and a deadly illness called SARS led to global travel warning. People reduced their demand for airplane transportations, and then airline companies save their budget on airplane. In addition, bursting of technology bubble caused a significant decline in airplane orders. Thus aircraft industry condition was the worst seen in a generation. At the same time, aircraft industry experienced a new change that mid-size plane which could travel long distance with lower operations cost is replacing old mid-size planes. On the other hand, defense industry benefited from the war and we foresee a growth in profitability for this industry.

1. Company-Specific Analysis & Problems

As the leader of aircraft industry, Boeing was not only impacted by the worst macro economy condition, but also faced with the challenge of Airbus, its major competitor. In 2002, Boeing’s commercial airplane deliveries dropped from 527 in 2001 to 381, and received only 176 orders, compared to Airbus’s 233. To realize a new progress on the development, Boeing announced plans to design and sell a new supper efficient “Dreamliner” called 7E7. However, the new plan will face many problems, such as the risks of composite material, feasibility of technology to extend snap-on wing and pressure of per-copy costs budget. After estimating future cash flows of this project, the company is facing the problem to choose an appropriate cost of capital to make a final decision.

1. Cost of Capital Estimation

① Cost of Equity

Risk-free Rate Selection:

We choose the yield, which is 4.18%, on the 20-year Treasury bond on June 16, 2003 because the 7E7 project investment period is 20 years.

Beta Selection:

For the American equity market, we usually use S&P 500 or NYSE composite index to represent the market return, and we normally use monthly returns in past five years to perform the regression because weekly returns may more volatile due to short intervals among them. In addition, we think S&P 500 can represent whole market more precisely because some big-name companies do not list on the NYSE market. So, we choose betas, which calculate against the S&P 500 for 60 months period.