advanced finance write up

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Kettlewell 1

Advanced Finance Project

Spring 2012

The Boeing Company

Mark Kettlewell



Kettlewell 2

Memorandum to the Chair of the Board of Directors

After extensive analysis of relevant data, I have come to the conclusion that the relevant

cost of capital for projects that have the same level of risk as the overall firm is 8.58% (Appendix

D). This number was calculated using the Weighted Average Cost of Capital method. More

broadly, between eight and ten percent is the relevant range given constant changes in themarket, assumptions within the models, and the reality of an uncertain investment environment.

Alternatively, if one assumes strictly equity funding, a discount rate of 10.96% should be applied

as dictated by the Asset Beta model (Appendix C). Again, a range of between ten and twelve

percent would be a reasonable estimate given inevitable uncertainty.

The weighted average cost of capital method requires a number of accurate inputs to

ensure a reasonable output. In this case, information was derived from a number of sources.

Morningstar Financial provided data on Boeing’s outstanding bonds, yield to maturity, and book

values. Dividend information, stock price, beta, earnings per share, and the value of the firm

were provided by Value Line. Using this information as a starting point, the weighted average

cost of capital was calculated using the average discount rate of the dividend growth model and

the capital asset pricing model as the cost of equity. The bond information was then incorporated

into the calculation.

The most important and influential factor in the calculation of the discount rate using the

capital asset pricing model is the figure chosen to represent the market rate of return. For this

figure, I used the same reference point that Value Line uses to calculate beta, the New York

Stock Exchange Composite Index. Because beta describes the correlation between a stock and a

reference basket of securities, I thought it was important to utilize the same resource.

This reference point resulted in a significantly higher discount rate than the dividend

growth model. Given the potential for error in both methods, I believe that each method

mitigates the shortcomings of the other, resulting in a more reliable figure.

The asset beta method yields a significantly higher discount rate due to its reliance on

more expensive equity funding. This figure is probably misleading. Because the firm uses a

combination of debt and equity for financing, the shareholders demand a higher rate of return in

exchange for their lower priority and the resulting higher risk. If there was no debt, as the asset

beta model adjusts for, shareholders would likely demand a lower rate of return in exchange for

the lower risk. The asset beta was calculated using the capital structure information from Value

Line as the basis for adjustment, and the beta from Value Line as the equity beta.

Again, the relevant discount rate is likely between eight and ten percent, with the

calculated figure being 8.58%(Appendix D). Using this discount rate should reflect a relatively

accurate company cost of capital.



Kettlewell 3

Boeing Discount Rate Expanded Explanation (To the President)

Two approached were used to estimate an appropriate discount rate for this project. The

first, weighted average cost of capital is logical and sound, given the context. The second, the

asset beta method, seems like a poor choice given the objective of the analysis.

The reason I say asset beta is a poor choice for this application is because it is specifically

designed to delever companies in order to provide an apples-to-apples comparison between

companies. We are only dealing with one company here with projects with the same amount of

risk as the overall firm. The asset beta can also be used to estimate the discount rate for new

projects in fields that the company is not currently involved in. This is done using the pure-play

approach, and again, does not apply here.

While I would recommend against its use in this context because I feel it is inappropriate

and misleading, I have calculated a discount rate. According to Value Line, the equity beta is

1.05. After adjusting for the firm’s capital structure with the asset beta model, I used the asset

beta as the beta in the capital asset pricing model. The asset beta calculated was 0.86 (Appendix

B). This procedure yielded a discount rate of 10.96% (Appendix C). Again, this assumes all-

equity financing which I believe is a mistake given Boeing’s capital structure.

There are a few other relevant inputs to asset beta. Figures for total market value and

long-term debt were obtained from Value Line. A risk-free rate of 1.96 was used. This was the

most recent figure available from the Department of the Treasury for ten year bond.

The final figure required to calculate a discount rate using the capital asset pricing model

is a market rate of return. Because my beta was drawn from Value Line, I decided to look up the



Kettlewell 4

reference index that Value Line employs to calculate beta. I found that Value Line uses the New

York Stock Exchange composite index as the basis of their beta calculations. I believe that in

order to use a correlation figure like beta effectively, you must use the same reference index as

the people who calculated the figure.

This number proved more difficult to procure than I imagined. Typical data sources such

as Yahoo and Morningstar only list the index price. Because this price does not reflect the

returns from dividends, it is useless for our purposes. The number required is the total return,

including capital gains and dividends. The source that I finally settled on was a paper presented

at a conference of the Accounting and Finance Association of Australia and New Zealand. The

gentleman who presented was Mahmoud Agha, an Assistant professor at the prestigious Western

University of Australia. Professor Agha holds a PhD in Finance and has years of experience in

the private sector in addition to his academic work.

Professor Agha calculated the “long-run average total return on NYSE Composite index

during the past 30 years as a proxy for the expected market return, which is found to be around

12.788%.” This number was a baseline calculation for more rigorous academic work. It does not

go back as far as I would like, and the source data would be better, but it was the best

approximation I could find to the reference index Value Line uses to calculate beta. 12.788%

was used as the market rate of return for every calculation requiring it. I felt that a less than

perfect source with the correct reference point for a correlation (beta) was better than a perfect

data source with a possibly flawed or irrelevant data set with regard to Value Line’s beta.

The most appropriate discount rate for Boeing to use is between eight and ten percent.

The precise rate calculated using the weighted average cost of capital was 8.58% (Appendix D).



Kettlewell 5

This figure was calculated using the market value of bonds and equity taken from Value Line,

bond details from Morningstar, dividend, earnings, beta, and share price information from Value

Line, and assumed a corporate tax rate of thirty-five percent. In addition, the New York Stock

Exchange composite index historical rate of return of 12.788% was used as the market rate of

return when calculating the required return on equity using the capital asset pricing model.

To calculate the weighted average cost of capital, one must first calculate the component

parts. As mentioned above, Boeing’s outstanding long-term debt was analyzed based on data

gathered from Morningstar. The total cost of debt was calculated as 2.87% (Appendix A). This

figure was a result of a weighted average that took into account current prices of most bonds, as

well as current yield to maturities. One discrepancy worth noting is that the total value of the

bonds listed on Morningstar summed to 8.118 billion dollars, while both Boeing’s annual report

and Value Line reported 10.018 billion dollars in long-term debt (Appendix D). Some of this

debt is classified as 144a, and can only be sold to private equity investors. In addition, financial

information on these bonds is not publicly available. In order to compensate, the market to book

ratio of the known debt was applied to the total long-term debt in order to convert the total

amount to market value. As it stands, the market value of Boeing’s long-term debt is estimated at

12.17 billion dollars (Appendix D). I felt this was prudent in order to weight both debt and equity

on the same basis, i.e., market value as opposed to book value.

The next step was to use the capital asset pricing model to calculate the cost of equity.

The risk free rate of 1.96% was used again for this calculation. The beta of 1.05 and the market

rate of 12.788% were also used, again from the same sources. This yielded a result of a 13.43%

cost of equity, which is close to the market rate of return as beta indicates it should be (Appendix

B).



Kettlewell 6

In order to cover all of the bases, I also calculated the cost of equity using the dividend

growth model. According to Value Line, Boeing paid a dividend of $1.68 per share this year and

Boeing’s share price is currently at $72.56. The most difficult part of using the dividend growth

model is determining a growth rate. I used two approaches to forecast this and decided on the

sustainable growth formula. This formula states that the return on equity, 6.64%, multiplied by

the plowback ratio equals the sustainable growth rate for the company. In this case the expected

growth rate came to 4.33% (Appendix B).

The alternative method, calculating a geometric average of past returns resulted in a

forecast dividend growth rate of 7.73%, which both exceeded Value Line’s dividend forecast and

failed the smell test (Appendix E). Dividend growth at that level seems unlikely for a mature

firm. That being the case, I used a 4.33% growth rate to calculate the cost of equity with the

dividend growth model, which resulted in a rate of 6.74% (Appendix B).

I believe the gap between the costs of equity between the two models is indicative of the

weaknesses of both. The dividend growth model is highly sensitive to dividend growth forecasts.

A growth rate of 4.33% seems reasonable, however, given the average return on equity of 5.0%

since 1998 (Appendix D). The capital asset pricing model assumes a much higher cost of equity,

because the baseline is the overall market. While Boeing is correlated closely with the overall

market, as is reflected in a beta of 1.05, the dividend has increased every year since 1990,

indicating steady cash flows even in periods of market volatility. This could explain the lower

cost of equity predicted by the dividend growth model.



Kettlewell 7

In order to take advantage of the merits of each model, I calculated them both and then

averaged them together. The result was a cost of equity of 10.09%. Given Boeing’s long,

relatively stable history, this number seems reasonable (Appendix D).

The cost of equity of 10.09% and the cost of debt of 2.87% were then used to calculate

the weighted average cost of capital, which came to 8.58% after accounting for the tax shield

value of the debt (Appendix D). This suggests a discount rate of between eight and ten percent

would be reasonable for new projects with the same level of risk as the overall firm.

Boeing’s cost of capital is likely lower than the overall market due to an outstanding

credit rating, a 300 billion dollar backlog of orders, and relatively stable contracts with the

United States government. These factors could help explain why investors are willing to accept a

lower return on equity than the capital asset pricing model alone would suggest.

In addition, a long-term Boeing investment, the 787 Dreamliner, is finally into production

after years of delays. These delays were a result of a variety of factors, mostly involving the new

technology. The 787 is composed in large part of carbon fiber. This has resulted in dramatically

lower weight which contributes to fuel efficiency. In addition, new, more efficient engines also

reduce costs. These innovations have resulted in an aircraft that is twenty percent more fuel-

efficient than any aircraft on the market.

These innovations have come at a cost. Boeing had to figure out to build a plane largely

from carbon fiber in a mass-production environment. They also had to engineer an engine that is

responsible for forty percent of the new gains in fuel efficiency. It’s easy to set targets like these,

but engineering new technology often takes longer than anticipated. It’s essentially invention on

a schedule.



Kettlewell 8

In addition to in-house design challenges, Boeing also attempted to cut costs on the new

aircraft by outsourcing some of the critical engineering work to outside firms to cut costs. In

several cases, the firms were simply not capable of completing the work, and Boeing was forced

to bring the design back in-house. This was more expensive and took longer than the initial plan

had allowed for.

Now that the 787 is in production, risks associated with investing in Boeing have

declined significantly. The 787 entering production has changed the project from a source of

negative cash flows to positive, and removed the uncertainty associated with the design phase.

The reduction of uncertainty would also suggest a lower cost of capital than the capital asset

pricing model might indicate.

The capital asset pricing model has value in this application in spite of its shortcomings.

The dividend growth model is extremely sensitive to a dividend growth estimate that is difficult

to forecast with precision. I used the average of these two approaches because I believe the

extremes represented by either one did not accurately reflect of Boeing’s risk.

The range of eight to ten percent stipulated earlier in this document represents the most

likely realistic cost of capital for Boeing going forward. Even if all of my calculations were

precise and accurate to the nearest basis point, the underlying assumptions governing the

calculations have already changed since I started writing this. A range of rates better reflects the

reality of the constantly moving market. Boeing’s gold-plated credit rating, order backlog, and

the successful development of a breakthrough technology should keep its cost of capital low for

the foreseeable future.



Appendix A Kettlewell

Source Data and Calculations on Boeing’s Long Term Debt

Name Maturity Date Amount in Millions Price

Coupon

Rate (%) YTM

% of

Debt

Weighted

YTM

Market

Value

Boeing 3.5% 2/15/2015 750 107.4 3.5 0.84 8.17% 6.86% 805.5

Boeing 4.875% 2/15/2020 750 118 4.875 2.33 8.97% 20.91% 885

Boeing 5% 3/15/2014 700 107 5 1.24 7.59% 9.42% 749

Boeing 1.875% 11/20/2012 700 100.3 1.875 1.28 7.12% 9.11% 702.1

Boeing 6% 3/15/2019 650 123.5 6 2.29 8.14% 18.64% 802.75

Boeing 5.125% 2/15/2013 600 103 5.125 1.28 6.27% 8.02% 618

Boeing 6.875% 3/15/2039 500 144.7 6.875 4.11 7.34% 30.15% 723.5

Boeing 3.75% 11/20/2016 500 110 3.75 1.48 5.58% 8.25% 550

Boeing 5.875% 2/15/2040 450 127.5 5.875 4.19 5.82% 24.38% 573.75

Boeing 6.125% 2/15/2033 400 124.8 6.125 4.31 5.06% 21.82% 499.2

Boeing 8.75% 8/15/2021 398 133.8 8.75 4.3 5.40% 23.22% 532.524

Boeing 7.95% 8/15/2024 300 149.2 7.95 3.11 4.54% 14.12% 447.6

Boeing 6.625% 2/15/2038 300 138.3 6.625 4.19 4.21% 17.63% 414.9

Boeing 7.25% 6/15/2025 250 131.4 7.25 4.13 3.33% 13.76% 328.5

Boeing 8.75% 9/15/2031 250 135.4 8.75 5.71 3.43% 19.60% 338.5

Boeing 8.625% 11/15/2031 175 150.6 8.625 4.66 2.67% 12.45% 263.55

Boeing 7.875% 4/15/2043 175 159.4 7.875 4.36 2.83% 12.33% 278.95

Boeing 6.875% 10/15/2043 125 129.8 6.875 4.99 1.65% 8.21% 162.25

Boeing 7.5% 8/15/2042 100 139.7 7.5 4.96 1.42% 7.03% 139.7

Boeing Cap Corp

Internotes 4.75% 5/15/2013 13.2 103.9 4.75 1.04 0.14% 0.14% 13.7148

Boeing Cap Corp

Internotes 6% 5/15/2012 7.366 100.9 6 0.69 0.08% 0.05% 7.432294

Boeing Cap Corp

Internotes 4.85% 5/15/2013 6.988 104 4.85 1.02 0.07% 0.08% 7.26752

Boeing Cap Corp

Internotes 4.65% 6/15/2013 4.676 104.5 4.65 0.7 0.05% 0.03% 4.88642

Boeing Cap Corp

Internotes 5.6% 7/15/2012 3.53 101.2 5.6 0.87 0.04% 0.03% 3.57236

Boeing Cap Corp

Internotes 5.8% 6/15/2012 2.226 101.3 5.8 2.93 0.02% 0.07% 2.254938

Boeing Cap Corp

Internotes 5.6% 7/15/2012 1.836 102 5.6 1.16 0.02% 0.02% 1.87272

Boeing Cap Corp

Internotes 5.5% 6/15/2012 1.8 100.9 5.5 1 0.02% 0.02% 1.8162

Boeing Cap Corp

Internotes 5.7% 6/15/2012 1.608 99.8 5.7 7.23 0.02% 0.12% 1.604784

Boeing Cap CorpInternotes 5.65% 6/15/2012 1.591 102.7 5.65 2.24 0.02% 0.04% 1.633957

Boeing Cap Corp

Internotes 4.75% 11/15/2013 0.436 101.6 4.75 3.86 0.00% 0.02% 0.442976

Total 8118.257

Cost of

Debt 2.87 % 9861.77

Market/book

Ratio 1.214764816



Appendix B Kettlewell

Capital Asset Pricing Model

1.96%

beta 1.05

12.79%

Expected Return 13.43%

Dividend Growth Model

1.68

72.56

g 4.33%

Expected Rate of Return 6.74%

New York Stock Exchange Composite Index Returns from 1971-2011 = 12.788%

Asset Beta

βequity 1.05 Equity CalculationEquity $ 54,109,498,563.28 Number of Shares Outstanding 745,720,763.00

Long Term Debt $ 12,169,513,924.41 Share Price $ 72.56

βassets $ 0.86 Total Market Value (Equity) $ 54,109,498,563.28



Appendix C Kettlewell

Capital Asset Pricing Model WACC calculations

WACC [= R A] = wD x [R D x (1-T)] + wE x R E

Equity Market Value $ 54,109,498,563.28

Bond Market Value $ 12,169,513,924.41

Corporate Tax Rate 35.00%

Cost of Equity 13.43%

Cost of Debt 2.87%

Weight of Equity 81.64%

Weight of Debt 18.36%

Total Market Value $ 66,279,012,487.69

Weighted Average Cost of Capital 11.30%

WACC calculated using Dividend Growth Model




Corporate Tax Rate 35.00%Cost of Equity 6.74%

Cost of Debt 2.87%





Asset Beta Calculation

1.96%

beta 0.86

12.79%

Expected Return 10.96%



Appendix D Kettlewell

Hybrid WACC Calculation

DGM Cost of Equity 6.74%

CAPM Cost of Equity 13.43%

Average 10.09%




Corporate Tax Rate 35.00%

Cost of Equity 10.09%

Cost of Debt 2.87%





Boeing’s Earnings Yield Since 1998

P/E ROE Dividend Earnings per share Retention Ratio Sustainable growth rate

1998 37.6 2.66% 0.56 1.15 51.30% 1.36%

1999 18.6 5.38% 0.56 2.19 74.43% 4.00%

2000 17.1 5.85% 0.59 2.84 79.23% 4.63%

2001 18.6 5.38% 0.68 2.79 75.63% 4.07%

2002 14.1 7.09% 0.68 2.82 75.89% 5.38%

2003 33.4 2.99% 0.68 1 32.00% 0.96%

2004 29.4 3.40% 0.85 1.63 47.85% 1.63%

2005 26 3.85% 1.05 2.39 56.07% 2.16%

2006 22.2 4.50% 1.25 3.62 65.47% 2.95%

2007 17.9 5.59% 1.45 5.26 72.43% 4.05%

2008 18.3 5.46% 1.62 3.63 55.37% 3.03%2009 24.1 4.15% 1.68 1.87 10.16% 0.42%

2010 14.7 6.80% 1.68 4.46 62.33% 4.24%

2011 14.5 6.90% 1.68 4.82 65.15% 4.49%

Mean 5.00% Average SGR 3.10%

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