Case Studies in Finance: Estimating the Cost of Capital

2017 Words Dec 4th, 2010 9 Pages

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
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239, 2007)3.
Using the formula (1): R = 4.56 + 1.73 * 6.4 = 15.63%
Therefore, the appropriate required rate of the return for evaluation the 7E7 project should be 15.63%.
The project’s estimated WACC
Cost of Debt
The cost of debt = the weighted average of all interest rates on outstanding bonds of The Boeing Company as of June 2003. The weighted average bond YTM interest rate was 5.33% (see exhibit 11 data calculation below). So the cost of Debt = 5.33%
Cost of Equity
From above, the cost of Equity = 15.63%
Capital Structure
The market value debt/equity ratio (Bruner, p. 252, 2007)3 is 0.525. We assumed that this ratio reflects Boeing’s capital structure target and that Boeing will finance the 7E7 commercial aircraft project equal to the firm’s capital structure. We call D and E as the percentage of Debt and the percentage of Equity. D/E = 0.525 or D = 0.525E (3) D + E = 1 (4) Substituting (3) into (4): 0.525E + E = 1
So E = 1/1.525 = 0.6557
Thus, from (4): D = 1 - 0.6557 = 0.3443

Weighted Average Cost of Capital
WACC = (percent Debt)*rd*(1-tc) + (percent Equity)*re (5)
Where: rd = Pretax cost of debt capital tc = Marginal effective corporate tax rate percent Debt = Proportion of debt in a market-value capital structure re = Cost of equity capital percent Equity = Proportion of equity in a market-value capital structure
Therefore, from the