CASE STUDY 3: ESTIMATING THE COST OF CAPITAL
The Capital Assets Price Model (CAPM) is used to describe the relationship between risk and expected return and is often used to estimate a cost of equity (Investopedia, 2009). The cost of equity(COE) of the discount rate is: R = Rf + β*(E - Rf) (1) Rf = Risk free rate of return, usually U.S. treasury bonds β = Beta for a company E = Expected return of the market (commercial airlines market) (E - Rf) = Sometimes referred to as the risk premium
The following table shows the average annual arithmetic returns investors earned on various asset classes over the period 1900 to 2003. (Source: Table …show more content…
251, 2007)3; the 7E7 commercial aircraft project is quite attractive for Boeing. For the first 20 years, the worst scenario is that the unit volume will be 1500 with a 0% price premium above expected minimum price. Even in this scenario, the IRR is still 10.5%, so the reason for going ahead with the project looks brightly. The WACC is estimated to be 11.44% while the Internal Rate of Return is expected to be 15.7%. Assuming no other alternative projects of greater potential are available to pursue, the excess will add value to Boeing’s stock, which will make the 7E7 project more valuable. At the date of the case, the stock price for Boeing is closed at $36.41. Thus, in the purpose to keep this stock price over the life of the 7E7 project, the rate of returns required from the project must be at least 11.44%.
On the other hand, based on the above calculations, the project appears to be economically reasonable. The cost of equity for this project should be 15.63%; however, in order to maintain the value of stocks, Boeing needs an 11.44% return from the 7E7 project. This means the company had a good safety margin in discounting cash flow to net present value.
b) Sensitivity analysis is a technique used to determine how varying independent variable values will impact a selected dependent variable under given assumption. Utilizing sensitivity analysis is a way to predict the outcome of a situation if key