Case 16 The Boeing 7E7

155

THE BOEING 7E7

Teaching Note
Synopsis and Objectives
In 2003, the Boeing Company announced plans to
build a new super-efficient commercial jet called the 7E7 Suggestions for complementary
or Dreamliner. This was a bet the farm gamble by cases on the cost of capital:
Teletech Corporation, 1996
Boeing, similar in magnitude to its earlier introductions of (Case 15); Nike Inc. (Case 14)
the 747 and 777 airliners. The technological superiority of and Coke vs. Pepsi (UVA-Fthe new airframe, as well as the fact that it would penetrate a 1340)
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 for students 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. The students 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, the students identify the key value drivers and distinguish, on a
qualitative basis, the key gambles that Boeing is making.
The general objective of this case is to exercise students skills in estimating a weightedaverage cost of capital and cost of equity. The need for students to estimate a segment WACC
draws out their 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. In doing so, students engage the
concept of value additivity.

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Case 16 The Boeing 7E7

Suggested Questions for Advance Assignment to Students

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
economically attractive?

is

the

project

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?
Supporting Excel Spreadsheets

Tip: The instructor can streamline

the discussion considerably by
dictating base-case assumptions
for student use regarding cost of
debt, risk-free rate, and equity
market
risk
premium.
Such
direction could be offered in the
assignment
questions.
Our
preference is not to dictate very
much, but rather, to let students
explore alternatives. The balance of
this note follows this path.
However, many schools have a
house view about the equity
market risk premium. For this
reason, the case does not cite an
EMRPthe instructor is assumed to
offer guidance here. At the date of
the case, the four main estimates of
EMRP were:
6.4%
(geometric mean over T-bills)
4.7%
(geometric mean over T-bonds)
8.4%
(arithmetic mean over T-bills)
6.4%
(arithmetic mean over T-bonds)
See the Appendix for definition and
discussion of the geometric and
arithmetic EMRPs. The calculation
in Exhibit TN8 illustrates the use of
the arithmetic mean over T-bills.

Student analysis of the case is supported by the spreadsheet file, Case_16.xls, available
from Darden Business Publishing ([email protected]). Instructor analysis is
supported by TN_16.xls. It is a condition of accessing this file that you agree not to share the
contents of the instructor file with students.
Hypothetical Teaching Plan
The following questions offer an outline for discussion leadership. These can be easily
condensed or expanded to meet a discussion time as short as 80 minutes and as long as 4 hours,
depending on the depth to which the instructor wishes to address the issues.

Case 16 The Boeing 7E7

157

1. Why is Boeing contemplating the launch of the 7E7 project? Is this a good time to do so?
This opening summarizes the basic facts, broad motives for the project, and the risks. The
objective for this part of the discussion is to set the tone for the case discussion, especially the
need to prepare a recommendation for Boeings board of directors.
2. Should Boeings Board approve the 7E7?
The instructor can take the students vote and then solicit a few opinions and summarize
key arguments on the chalkboard. One can ask specific students for their estimate of the cost of
capital and write it next to their yes or no vote. The students will show some division of opinion,
but in our classroom experience, they tended to lean toward approval. The instructor could easily
take a devils advocate approach toward the prevailing sentiment and invite defense of the
students opinions. In any event, acknowledgment of a range of estimates builds drama and
confirms that there are competing views among studentsthis motivates a detailed discussion of
the financial analysis.
3. How would we know if the 7E7 project will create value?
Students may be familiar with the classic NPV criterion. This case invites them to focus
on the internal rate of return (IRR). If the IRR is greater than the project cost of capital, the 7E7
is a positive net present value project.1 A discussion of why this is true provides a solid big
picture foundation for the case decision. The project IRRs are presented in case Exhibit 9.
Therefore, the focus of student analysis should be on determining the benchmark against which
to evaluate the IRRs. Thus, this part of the discussion helps to motivate the analysis of WACC.
Some students may have voted in a manner that contradicts the IRR versus the cost of capital
decision rule. This sets up the next question.
4. Okay, lets examine the details of how to estimate the WACC. Lets go step-by-step. Where
shall we get started?
The instructor can ask one student (or team of students) to walk the class through the
detailed calculations. The presenter(s) may make one or more errors or adopt some controversial
practice in making the calculations. This presents a strategic teaching question for the instructor:
interrupt and correct at the first mistake, or do it after they are done? The latter is preferable if
you are in a discussion-based learning environment. Thus, the instructor could keep a careful
record of the students calculations on the chalkboard,2 let them finish, and then turn to the class
and ask, Do you all agree? Why not? Challenges and debates over specific issues will follow.
At this point, it is not important to judge the quality of the assumptions (they can be good or
1

Of course, this assumes initial negative cash flows followed by positive cash flows.
This class is ideally suited for the chalkboard. PowerPoint or other digital media make it difficult to summarize
the complete analytic process in plain view of the students and simply puts the success of the whole class in the
hands of the presenters. The instructor needs to remain in control of the discussioncontinuing to hold the chalk is
the best way to do this.
2

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Case 16 The Boeing 7E7

bad). The task of the instructor is to work through the WACC calculation in an orderly manner. A
number of thought-provoking questions about techniques can lead to rich classroom discussions.
By the close of this segment of the discussion, the instructor should aim to have on the
chalkboard a finished WACC calculation that highlights aspects about which there may be some
disagreement.
5. The weighted-average cost of capital is a simple formula. Yet it seems that reasonable
people can disagree about the estimates. How can there be such a range of cost of capital
estimates? Please summarize the issues.
This segment asks the students to summarize the thorny questions of estimating WACC
and to contrast the issues in practice with the underlying simplicity of the weighted-average cost
of capital formula and the capital asset pricing model. The reason for varying estimates is that
students will have made different assumptions as they apply the formula. This will be apparent
on the chalkboard if the instructor has faithfully recorded the assumptions of the main
presenter(s) and any alternate assumptions that may have surfaced. The next step is to do
sensitivity analysis on each assumption. If the sensitivity analysis reveals that the decision
outcome is significantly impacted by the assumption, only then is it worth spending more time,
energy, and dollars on improving the quality of the assumption. This is another judgment part of
financial analysis and decision-making. A good analyst will make the board aware of critical
assumptions, so that it can, in turn, make more informed and better decisions.
6. Have we thought of everything? Is there anything else the board of directors should
consider in assessing the financial appeal of this project? Why might the board vote
yes on the 7E7, when the cost of capital estimate is greater than the IRR? Why might
the Board vote no if the cost of capital estimate is less than the IRR?
This segment of the discussion should aim to introduce the basic idea that determinate
cash flow forecasts do not capture contingent values. Real option valuation is beyond the scope
of this case, but students should be reminded that a large capital project such as the 7E7 is
probably riddled with rights that can enhance the value of the projectrights to new yet-to-be
discovered technology, rights to grow and/or enter new markets, and rights to cross-pollinate
other projects new intellectual property from the 7E7. In addition, the 7E7 might create
intangible value for Boeings brand and strategic value for cross-selling. The potential
significance of qualitative issues can be an eye-opening point for some students who consider
finance to be a numbers class. In the end, the board of directors must weigh both the
determinate cash flow values and the contingent and intangible values in the project.
7. What should the board do?
The instructor could bring closure to the discussion with another student vote. Making
careful note of students who may have changed their minds, the instructor could invite one or

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159

two to comment on what they learned. Airing the reasoning behind some of the vote changes will
reinforce the learning objectives underlying the decision-making process.
The instructor could close the class with a brief commentary on development of the 7E7
project since the date of the case. The epilogue presented in this note recounts the boards
decision to proceed with the 7E7 project. Further developments may be gleaned from Boeings
Web site and others.
Case Analysis: Estimation of the Project-Specific WACC
Launch and timing of the 7E7
The motives for the project are laudable: the 7E7 is entering
a good growth segment of the industry. Higher performance and fuel
efficiency will position Boeing favorably in the market, and perhaps,
take back some market share from competitors. R&D on this project
may create inventions that will prove to be valuable to other Boeing
products. At the same time, the consequences of error are staggering:
this is a bet-the-ranch kind of investment.

Question 1: Why is
Boeing contemplating the
launch of the 7E7 project?
Is this a good time to do
so?

But, as most entertainers know, timing is everything. Here, the timing could not be worse:
war, airline-focused terrorism, SARS, and the weak financial condition of airlines all challenge
the approval of the project. Why now? is a question that the board must answer. In part, the
answer depends on the long development cycle (four years) and very long product lifecycle (20
years). The board is making a bet less on conditions that prevail today than on conditions that are
expected to prevail many years into the future.
Calculating WACC
The instructor could use the formulas for WACC and the
capital asset pricing model as a format for organizing the calculation
section of the discussion.
1. WACC = (% debt)(rd)(1 tc) + (% equity)(re)
where:

Question 4: Let us
examine the details of how
to estimate the WACC. Let
us go step-by-step. Where
shall we get started?

rd = required rate of return of debt

re = required rate of return on equity (cost of equity)
tc = marginal effective corporate tax rate
% debt = debt divided by sum of debt plus equity, measured at market value
% equity = equity divided by sum of debt plus equity, measured at market
value. Market value of equity is simply share price times number of shares.
Many analysts simply approximate market value of debt with its face or book

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Case 16 The Boeing 7E7

value. In most instances, this is not an unreasonable practice: for floating-rate

debt issues (such as bank loans) market value will equal book value; for fixedrate issues, book value may be a close substitute for market value, where the
bond was issued at face value, and the credit quality of the issuer and the
general level of interest rates have not changed since date of issue.
2. Calculating the cost of equity (re)
Per the CAPM, re = rf + e (rm rf)
Where rf is the risk-free rate, rm rf is the market-risk premium and e is the beta of
equity.
One can leave the formulas on the board so that students are
able to see what the class is working toward, as a simple
organizing framework; but this simplicity is deceptive. The
theory says relatively little about the practical application of
those models. Reasoning from first principles, one can make
good headway in estimating the cost of capital. The kinds of
issues that will occupy the student include the following:

Question 5. The weighted-average

cost of capital is a simple formula.
Yet it seems that reasonable people
will disagree about the estimates.
What are the points of contention in
estimating the cost of capital?
Please summarize the issues.

Choice of models: Students may wonder why the capital asset pricing model is not used
to estimate the firms cost of capital directly. The answer is that it can be used in such a fashion,
but in practice is almost never used for that purpose. A true asset beta is unobservable because
the items on the left-hand side of the balance sheet are ordinarily not traded in liquid markets. In
theory, one could derive a beta for debt and a beta for equity and then weight them according to
the market values of their securitiesthis should give an estimate for the firms asset beta.
Alternatively, one could unlever the equity beta to get an asset beta. Inserting the asset beta into
the CAPM would, in theory, yield an estimate of the firms cost of capital. But these latter two
methods invite estimation error. A survey of best practice firms, 3 however, revealed a total
preference for using the WACC formula and for restricting CAPM to estimating the cost of
equity.
Beta for the 7E7 project: The tendency of novices will be to use Boeings equity beta
from case Exhibit 10 as an input to the CAPM. This would be inappropriate since 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. Somehow, for the cost of capital to be
meaningful we have to back out the commercial risk from the defense risk and use a beta
reflecting commercial risk in the CAPM. The class could discuss whether one would expect a
commercial beta to be higher or lower than a defense beta and whya strong case could be
made that defense would have a lower beta, reflecting the zero default risk of Boeings
3

See the study Best Practices in Estimating the Cost of Capital: Survey and Synthesis, Financial Practice
and Education (Spring/Summer 1998) by Robert F. Bruner, Kenneth M. Eades, Robert S. Harris, and Robert C.
Higgins.

Case 16 The Boeing 7E7

161

government clients and the long cost-plus contracts. It is useful to exercise students intuition
about risk.
Estimates of beta: Case Exhibit 10 poses two basic choices: first, what to use as a proxy
for the market when regressing equity returns on market returns; and second, over what period of
time the beta should be measured.
Ideally, beta should be derived by regressing Boeings equity return against the return on
the basket of global assets (i.e., the market return). Measuring the return on the global asset
portfolio is, as a practical matter, proxied by returns on equity market indexes. In bridging theory
with practice, the greater the value captured by the index, the more closely it matches the theory.
In case Exhibit 10, students have a choice between the New York Stock Exchange (NYSE)
composite index and the S&P 500 index. Of those two, the NYSE is a broader and higher value
index. This provides a beta range between 1.00 and 1.62.
Next, students have to choose whether to estimate beta across the 60-day, 21-month, or 5year period. Beta is the markets instantaneous perception of risk and moves on a second by
second basis just like stock prices. However, since this is unobservable, we are forced to use
historic data to estimate the markets perception of risk today. The question therefore is what
historic period best reflects the risk of the commercial aircraft industry as perceived by the
market at the time of the decision?
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 21-month beta runs from September 17, 2001, and therefore includes significantly more
terrorism risk. The 60-month beta dilutes terrorism, war, and SARS risk by going as far back as
June 16, 1998. Students will want to have a discussion of what time period to use as it relates to
the commercial-aircraft industry, however, this may be a good time to emphasize the point that
such a discussion is only productive after doing sensitivity analysis with the different betas. For
now, this is a benchmark case, and it is only important to keep track of all assumptions. For
purposes of illustration, this note uses the 60-day beta of 1.62.
Calculating a beta for Boeings commercial division: Exhibit TN1 shows pictorially the
underlying logic in calculating the commercial beta. Step 1 is to use the unlevered beta formula
to determine what the beta would have been if Boeing had no debt. 4 If Boeing had no debt, then
the unlevered beta on the right-hand side of the balance sheet would be equal to the beta on the
left-hand side: Boeings asset beta. In step 2, the hypothesis is that Boeings asset beta is a
weighted average of its commercial and defense beta.
Exhibit TN2 shows a brief derivation of the unlevered beta formula. It may be
appropriate to discuss the assumptions underlying the formula, and whether or not those
4

For a detailed exposition of unlevered beta, see Ross, Westerfield, and Jaffe, Corporate Finance, 6th ed.,
(2001), 481484.

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Case 16 The Boeing 7E7

assumptions are reasonable as they pertain to Boeing. The formula assumes riskless debt and that
the only impact of debt on the value of the firm is the corporate debt tax shield. The formula for
the debt tax shield (tcD) assumes permanent debt and that the company will be permanently
profitable enough to use the tax shields.
Exhibit TN3 shows Boeings unlevered beta with inputs from case Exhibit 10, using the
60-day beta as measured against the NYSE as the levered equity beta. Exhibit TN4 illustrates
the idea that the unlevered beta of 1.21 is a weighted average of Boeings commercial and
defense division betas. To solve for the commercial Boeing beta, it is necessary to determine a
defense beta and to decide how to estimate the percentage division weights. This process can
entail some interesting questions that result in rich classroom discussion, around issues such as:
Weights for defense and commercial segments: To bridge theory with practice, in
answering this, the template is the same as before. First, what should the weights be in theory? In
theory, they should be the market value of Boeings defense and commercial assets. Case Exhibit
1 shows Boeings revenues, operating profits, and identifiable assets broken up by the
commercial and defense segments. Each of those measures has advantages and disadvantages as
a proxy for the market value of assets. A discussion of the merits of each measure will again
emphasize the importance of applying judgment when bridging theory with practice. As a
benchmark case, we use the percentage of revenues as weights (also shown in case Exhibit 10).
Betas for defense and their unlevering: Case Exhibit 10 shows defense betas for Northrop
Grumman and Lockheed Martin, which both have over 90% of their revenues coming from
defense. If we assume that they are 100% in the defense business then 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. Throughout this case discussion, students may mix assumptions. Internal
consistency is important. Hence, the relevant betas are 0.34 and 0.27. Some students may be
tempted to average these levered betasbut doing so would reflect the financing decisions of the
peer firms and not that of Boeing. What the calculation requires is the unlevered beta of the
defense segment. Therefore, the betas of Lockheed and Northrop must be unlevered and then
averaged as shown in Exhibit TN5. Two points emerge. First, it makes sense to average
Lockheed Martin and Northrop Grumman betas of 0.29 and 0.21 respectivelythis simply
draws on the greater information embedded in two (rather than, say, one) observations. The
average is 0.25. The two peer betas are less than 0.1 apart, relatively tightly clustered. Second,
based on an earlier discussion, students should already have expected the defense business to
have a lower beta than the commercial business.
Beta for commercial segment: As shown in Exhibit TN6, the commercial beta is 2.03,
greater than the defense segment betas as expected. At this point, the 2.03 commercial beta is
unlevered. If you applied this beta to the CAPM, you would be obtaining a discount rate for the
commercial aircraft business and there would be no need to use the WACC formula. While this is
technically correct, you would not be using market provided information on debt at the time of
the case. Hence, a superior approach would be to relever the 2.03 to obtain a beta to use in
CAPM to calculate the cost of equity based on commercial risk. Exhibit TN7 contains

Case 16 The Boeing 7E7

163

commercial betas consistent with a range of assumptions the instructor might encounter in class
the range spans the values 1.04 to 3.31.
Calculating cost of equity: Exhibit TN8 shows the remaining inputs and calculations
needed to estimate Boeings commercial cost of equity. Capital-asset pricing theory gives no
guidance about which risk-free rate of return to use. The case includes both a three-month and a
30-year choice of Treasury rates in June 2003. Some students will point out that a longer-term
rate is warranted to match the length of the project. Others may point out that default is less
likely in the shorter term, so a short-term rate more closely matches the theory. My response is
that both arguments have merit and remain unresolved theoretical territory. However, sensitivity
analysis typically reveals that this is not an important pragmatic issue. The illustrated calculation
of WACC in this note 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%. The WACC would change to 15.6% if the 30-year T-bond
rate were used (based on the arithmetic equity risk premium).
In theory, the CAPM reflects the markets assessment of the premium today. Similar to
beta, current practice uses historic data to make this estimate. Hence, the time period over which
the average is measured can be subject to meaningful judgment. For example, does the last 20
years or last 74 years better reflect the markets assessment of the premium today?
Exhibit TN9 gives the range of equity cost estimates consistent with various
assumptions. The largest variation in estimates is due to assumptions about beta and the equity
market risk premium. Estimates span the values from 10.19% to 28.65%.
Calculating the cost of debt (rd): Case Exhibit 11 provides the information needed to
calculate Boeings cost of debt. The approach is to use a market value weighted average of yields
to maturity of Boeings different debt issues as of June 2003. Exhibit TN10 shows the
calculations. A caveat in the calculation is that case Exhibit 11 does not include all of Boeings
debt. It is missing short-term debt as well as debt issued by Boeings financing subsidiary:
Boeing Capital Corporation. In theory, a weighted average of all debt reflects the debt
component risk on the left-hand side of the balance sheet. In practice, the yields of debt issued by
Boeing Capital would be accessible information and this compromise in the calculation would
not be necessary. Given this caveat, some interesting questions can be discussed:
1. Is debt not also subject to commercial and defense risk, and should we therefore not try
to back out the commercial risk component?
While this point is perfectly valid, it is much less of an issue than equity since debt is a
senior security.
2. Why not simply use the CAPM to estimate the cost of debt?

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Case 16 The Boeing 7E7

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.
3. Should you calculate a weighted average of all debt or a weighted average of long-term
debt with maturities that match the length of the project?
Theory tells us that a weighted average of all debt risk is a function of the asset risk on
the left-hand side of the balance sheet. However, it is a matter of debate whether one should
further sort debt risk by matching debt maturity to the length of the project. While picking a debt
instrument whose maturity matches the length of the project may be pleasingly intuitive, a
counterargument would be to ask: what if Boeing only had short-term debt? In the case of
Boeing, sensitivity analysis reveals little difference between the two approaches. A weighted
average of all debt maturing on or after the year 2031 (maturities ranging from 2739 years)
results in a cost of debt of 6.03%. This compares to 5.33% using a weighted average of all
available debt information. This would change the WACC from the base case of 16.7% to 16.9%.
Tax rate: The theory requires an analyst to use the marginal, expected tax rate. Some
students may use historical, average tax rates (which they derive by dividing annual tax expense
by pretax profits). As the case notes, Boeings tax exposure has been lower in the past than it is
expected to be in the future; using the marginal effective tax rate of 35% is, therefore, more
appropriate.
Capital-structure weights: The theory requires an analyst to use market value, not book
value, weights. Case 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 WACC estimate: With all the assumptions given in this illustration, Exhibit TN11
shows the base-case estimate of the WACC to be 16.7%, greater than the base-case IRR scenario
of 15.7%. This appears to be an economically unattractive project. The only way to establish a
level of confidence with this conclusion is to test WACCs sensitivity to variations in the
underlying assumptions. Exhibit TN12 presents a range of WACC estimates consistent with
various assumptions that the instructor might encounter. The revelation is that the vast majority
of the estimates are smaller than 15.7%. A key difference has to do with the term of the beta used
in the estimate.
The 60-day beta, for example, gives heavy weight to the Iraq war and SARS. If you
believe that SARS and war will have an ongoing and significant risk to the commercial-aircraft
industry, then this should be your beta of choice. Conversely, you could argue that the 21-month
beta (beginning September 2001) places more weight on the broader history of two wars

Case 16 The Boeing 7E7

165

(Afghanistan and Iraq) and the general risk of terrorism. The 60-month beta dilutes impact of
terrorism, war, and SARS risk.
Need for a view: Plainly, the practitioner needs to have a view about political and
economic fundamentals in the future. How one gains such a view is beyond the scope of this case
discussion, although the instructor could point out that numerous courses in a typical business
degree program arm the analyst with tools and concepts useful in forming a view. History is one
guide to what might happen in the future. Only 12 years earlier, Boeing committed to build the
777 aircraft in the face of a similar economic and political environment. Though history is never
a perfect guide, it lends more insight than random guesses or agnosticism. In the final analysis,
the numerical analysis is not enough; it must be supported by some kind of outlook.
The Problem for the Board of Directors
This phase of the discussion, in effect, shifts in order to
reflect on the limitations of DCF analysis of projects. In short,
methods that focus on the time value of determinate cash flows
do not capture contingent cash flows, and by its very focus on
the project, the forecast of cash flows may ignore other
economic benefits outside of the 7E7 project, or in the realm of
intangible value. The wise analyst understands that DCF likely
tells only part of the story. The wise board of directors will
ruminate over the range of effects that DCF might miss. These
other factors might compel a board to approve a project whose
IRR did not exceed its WACC, or alternatively, to reject a
project when the IRR did exceed the WACC. Issues specific to
this case that students might offer include these:

Question 7. Have we thought of

everything? Is there anything else
the board of directors should
consider
in assessing the
financial appeal of this project?
Why might the board vote yes
on the 7E7 when the cost of
capital estimate is greater than
the IRR? Why might the board
vote no if the cost of capital
estimate is less than the IRR?
Question 8. What should the
board do?

1. Strategic options: Perhaps this project creates rights or options; perhaps not undertaking
this project would limit or shorten Boeings strategic flexibility elsewhere in the industry.
Airbus has already overtaken Boeing in this industry by many measures, and, perhaps
without the 7E7, Boeing would essentially relinquish permanent and dominant control of
this industry. If they ever tried to re-emerge as a commercial aircraft industry leader,
would they have that ability?
2. Growth and R&D options: Rights to grow in new markets are valuable options:
arguably, the 7E7 positions Boeing favorably with opportunities to grow in the regional
jet market. Technological spin-offs, from the 7E7 project to other projects at Boeing,
create technology options for the companyinnovations in the use of composite
materials and fuel-saving designs can position Boeing to compete more effectively
against Airbus.
3. Related activities in other divisions: The new product line will augment Boeings
aftermarket parts and service business. Unclear from the forecast is the extent to which

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Case 16 The Boeing 7E7

this activity is captured in the 7E7 projectionsbut even if it is, perhaps there are scale
economies in parts and service that the 7E7 will help other divisions of Boeing exploit.
The board should also scrutinize opportunities for effective risk management through
operations that could reduce Boeings exposure on this project. For instance, case 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.
Ultimately, Boeing is in the business of building airplanes. No doubt, the board and
senior management will feel a strong impulse to approve the 7E7 project, as a statement about
Boeings commitment to the commercial airplane business. The mission of the firm is an
extremely important consideration in the review of a project such as this. But the financial staff
must lend some discipline in pursuit of the mission. The 7E7 project is certainly not the only new
airframe opportunity facing Boeing. Project analysis needs to establish the attractiveness of this
project at this time.
In the end, the board would probably be reluctant to concede an attractive market
segment to competitors, but would impose risk management conditions that would protect the
firm. This is how the board proceeded.
Epilogue
In an unprecedented and highly risky move, in September 2003, the board voted to take
orders for the 7E7 on a limited basis. Specifically the board provided permission to offer the 7E7
to Japans two largest airlines: All Nippon Airways and Japan Air Lines. It was considered
particularly risky, however, to launch the 7E7 without a major U.S. customer. For example, when
Boeing developed the 777, they worked closely with their U.S. customers, who in turn had
significant influence on the planes design. While the Asian market was forecasted to be the
largest growth market, the needs of the Japanese were short range, while the needs of the rest of
the world were longer range. Boeing, therefore, was now considering three versions of the 7E7 to
accommodate the Asian market and the markets outside Asia. Multiple models however typically
drive up development costs, and the board had already stated that they would not back the 7E7
unless development costs were lower than what it took to develop the 777.

Case 16 The Boeing 7E7

167

In December 2003, the board unanimously voted to give its sales force the authority to
offer the 7E7 worldwide. Missing from this announcement, however, was any airline that had
agreed to buy the plane so early in the process. To get updated information on Boeings aircraft
orders, go to Boeings commercial aircraft Web site: www.boeing.com/commercial. On this page,
one finds the option to obtain commercial airplane info, which provides ordering and delivery
information.

Exhibit TN1
THE BOEING 7E7
Boeings Commercial Beta (1)

Case 16 The Boeing 7E7

167

168

Exhibit TN2
Unlevered Beta Derivation

Case 16 The Boeing 7E7

THE BOEING 7E7

Exhibit TN3
THE BOEING 7E7
Sample Illustration: Boeings Unlevered Beta

Case 16 The Boeing 7E7

169

Boeings Commercial Beta

Case 16 The Boeing 7E7

THE BOEING 7E7

170

Exhibit TN4

Exhibit TN5
THE BOEING 7E7
Example: Unlevered Defense Beta of 0.25

Case 16 The Boeing 7E7

171

Example: Boeings Commercial Beta

Case 16 The Boeing 7E7

THE BOEING 7E7

172

Exhibit TN6

Exhibit TN7
THE BOEING 7E7
Range of Unlevered Beta Estimates for Commercial Segment

Case 16 The Boeing 7E7

173

174

Exhibit TN8
Example: Commercial Cost of Equity

Case 16 The Boeing 7E7

THE BOEING 7E7

Exhibit TN9
THE BOEING 7E7
Range of Cost of Equity Estimates

Case 16 The Boeing 7E7

175

Boeings Cost of Debt

Case 16 The Boeing 7E7

THE BOEING 7E7

176

Exhibit TN10

Exhibit TN11
THE BOEING 7E7
Example: WACC Estimate for Commercial Segment

Case 16 The Boeing 7E7

177

178

Exhibit TN12
THE BOEING 7E7

Case 16 The Boeing 7E7

Range of WACC Estimates

180

Case 16 The Boeing 7E7

Appendix
THE BOEING 7E7
Background Comments on the Equity Market Risk Premium
The theory of capital asset pricing gives no guidance on its practical application. Finance
theory says the equity market risk premium should equal the excess return expected by investors
on the market portfolio relative to riskless assets. How one measures expected future returns on
the market portfolio and on riskless assets are problems left to practitioners. A survey of best
practice financial offices, by Bruner, Eades, Harris, and Higgins 5, on the estimation of the cost
of capital, found that practitioners disagree most sharply on the question of the measurement of
the equity market risk premium. Scholars, too, offer a wide range of views, as summarized in a
roundtable discussion by Ivo Welch.6 Because expected future returns are unobservable, best
practice is to extrapolate historical returns into the future on the presumption that past
experience heavily conditions future expectations. Where practitioners differ is in two
dimensions:

use of arithmetic versus geometric average historical equity returns

choice of realized returns on T-bills versus T-bonds to proxy for the return on riskless
assets.

The arithmetic mean return is the simple average of past returns. Assuming that the
distribution of returns is stable over time and that periodic returns are independent of one
another, the arithmetic return is the best estimator of expected return.7 The geometric mean return
is the IRR between a single outlay and one or more future receipts. It measures the compound
rate of return investors earned over past periods and accurately portrays historical investment
experience. Unless returns are the same each time period, the geometric average will always be
less than the arithmetic average and the gap widens as returns become more volatile.8
The standard source for measured equity market risk premiums is Stocks, Bonds, Bills,
and Inflation, an annual yearbook published by Ibbotson Associates. As noted on page two of
this teaching note, Ibbotsons estimates of EMRP from 1926 to 2003, offer a relatively wide

Robert F. Bruner, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins, Best Practices in Estimating
the Cost of Capital: Survey and Synthesis, Financial Practice and Education (Spring/Summer 1998).
6
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=234713
7
Several studies have documented significant negative autocorrelation in returnsthis violates one of the
essential tenets of the arithmetic calculation, since if returns are not serially independent, the simple arithmetic mean
of a distribution will not be its expected value. The autocorrelation findings are reported by: Fama and French
(1986), Lo and MacKinlay (1988), and Poterba and Summers (1988).
8
For large samples of returns, the geometric average can be approximated as the arithmetic average minus onehalf the variance of realized returns. Ignoring sample size adjustments, the variance of returns in the current example
is 0.09 yielding an estimate of 0.10 2(0.09) = 0.055 = 5.5% versus the actual 5.8% figure. Kritzman (1994)
provides an interesting comparison of the two types of averages.

Appendix (continued)
range of values, depending on use of the geometric as opposed to the arithmetic mean equity
return and on use of realized returns on T-bills as opposed to T-bonds.
Even wider variations in market risk premiums can arise when one changes the historical
period for averaging. Extending U.S. stock experience back to 1802, Siegel 9 shows that historical
market premia have changed over time and were typically lower in the pre-1926 period. Visual
inspection of the Ibbotson estimates shows considerable variation in historical premia over
different time periods and methods of calculation, even with data since 1926.
The survey by Bruner et alia found that a majority of texts and trade books support use of
the arithmetic mean return over T-bills as the best surrogate for the equity market risk premium.
Half of the financial advisors queried use a premium consistent with the arithmetic mean and Tbill returns, and many specifically mentioned use of the arithmetic mean. Corporate respondents,
on the other hand, evidenced more diversity of opinion and tend to favor a lower market
premium of about 6%.
This variety of practice should not come as a surprise since theory calls for a forwardlooking risk premium, one that reflects current market sentiment and may change with market
conditions. What is clear is that there is substantial variation as practitioners try to operationalize
the theoretical call for a market risk premium.
As a practical matter, the best practice in the estimation of WACC is to adopt a house
view. This view is driven by values and beliefs about markets and analysis. For instance, the
analyst could consider these points:

We do not calculate the cost of capital, we estimate it. This means that any WACC should
be viewed as having a range of uncertainty surrounding it. We cannot eliminate the
uncertainty; but best practice should aim to narrow the range. Uncertainty about EMRP is
one source of uncertainty in our estimates of WACC. One response is to embrace this
uncertainty in the analysis of projects, mainly by conducting sensitivity analysis of IRRs
and NPVs, as driven by the range of WACCs.

The choice of T-bills or T-bonds as the basis for EMRP depends on ones view about the
best way to impound inflation expectations in project analysis. Treasury instruments
capture inflation expectations prevailing for the life of the instrument. A common
practical response is to use a Treasury instrument that is contemporaneous with the life of
the asset being valued. The Boeing 7E7 is a long-lived project and, therefore, could be
gauged against the T-bond-based EMRP.

The choice of geometric versus arithmetic is simply irresolvable. Both methods have
desirable attributes and weaknesses. Here, thoughtful practitioners choose a method of
calculation that yields results that seem reasonable.

Jeremy J. Siegel, The Equity Premium: Stock and Bond Returns Since 1802, Financial Analysts Journal 48,
1 (January/February 1992): 2846.