Beta for the 7E7 project: Its inappropriate to use to use Boeings equity beta from case Exhibit

10 as an input to the CAPM, becasue this would assume that Boeings commercial aircraft risk is equal to Boeings firm risk. However, Boeings firm risk is a blend of both commercial and defense risk. a strong case could be made that defense would have a lower beta, reflecting the zero default risk of Boeings government clients and the long cost-plus contracts. In case Exhibit 10, the NYSE is a broader and higher value index. This provides a beta range between 1.00 and 1.62. Using a 60-day beta regression includes the trading dates between March 20 and June 16, 2003. This time period includes the Iraq war as well as the peak of the SARS travel warnings. The formula assumes riskless debt and that the only impact of debt on the value of the firm is the corporate debt tax shield. As a benchmark case, we use the percentage of revenues as weights (also shown in case Exhibit 10). Exhibit 10 Assuming both North and Lock are 100% in the defense business, we can use their betas to proxy for defense. We should use the 60-day NYSE betas to be consistent with the earlier steps in the example. WACC uses as the risk-free rate the three-month T-bill rate in June 2003 of 0.85%, which results in a WACC of 16.7%. Why not simply use the CAPM to estimate the cost of debt? While the beta of each debt issue is possible to estimate if it is traded publicly, and while CAPM is not restricted to equity instruments in theory, solving for a bonds yield to maturity (YTM) using existing market data avoids all the assumptions and weaknesses inherent in CAPM. The only reason we are forced to use a model like CAPM in estimating equity is that, unlike a bond instrument where coupon and principal payments are known with a fair degree of certainty, we do not know what cash flows to expect over the potential infinite life of the equity security. Tax rate: The theory requires an analyst to use the marginal, expected tax rate. Exhibit 10 provides the market value debt/equity ratio for Boeing as 0.525. From this, you can derive the percentage debt and equity to be 34.4% and 65.6% respectively. The board should also scrutinize opportunities for effective risk management through operations that could reduce Boeings exposure on this project. For instance, Exhibit 9 shows that the IRR is very sensitive to both development and production costs. If the percentage of COGS/sales goes from 80% (base case) to 84%, then the IRR plummets from 15.7% to 10.3%. This sensitivity suggests that innovations in manufacturing processes, purchasing, and assembly might have a very large beneficial impact on the profitability of the projectif they pay. Another form of risk management by the board would be to establish milestones at which progress on the project would be reviewed and changes made, if necessary. Tailoring managerial incentive systems to keep within the financial parameters is another form of risk management. Students may summon more examples of techniques that can limit Boeings downside on the 7E7.