CORPORATE FINANCEVII

ESCP-EAP - European Executive MBA

25&26 January 2006, Berlin

Risk adjusted hurdle rates

Levered vs unlevered betas

Boeing 777 case studyI. Ertürk

Senior Fellow in Banking

What is the WACC for 777We need a WACC that represents the risk (ß) and capital structure (D/E) of manufacturing commercial aircraft.Composite WACC, ß, and D/E are not appropriate.From the composite levered ß of Boeing, which is an average of defence and commercial businesses we need to estimate unlevered ß of the commercial aircraft business.What is then ß for the commercial aircraft business?

%2.13

%)4.5(81.0%82.8

)(

e

e

fmfe

r

xr

rrrr

Boeing composite cost of equity and WACC

%1.13

%2.1326.168,15

76.896,14%73.9

26.168,15

5.271)34.01(

)1(

WACC

WACC

rV

Er

V

DTcWACC

ED

80.0

14,896.76

271.50.34)-(11

81.0

ED

)T-(11

E

D)T-(11

U

c

U

cUL

L

unlevered composite ß for Boeing

business commercial ofweight

)business defense of(weight -

)business commercial of(weight )business defense of(weight

UdefenseUcompositelUcommercia

lUcommerciaUdefenseUcomposite

ßUcomposite = 0.80

asset weight of defense = 6,603/13,278=49.7%

asset weight of commercial = 6,675/13,278=50.3%

ßUdefense = average of ßUdefense of “pure” defense companies

Grumman, Northrop and Lockheed are proxy for “pure” defense companies

What is ß for commercial aircraft manufacturing business?

ßL ßU

---- ----Grumman 0.80 0.37Northrop 0.74 0.40Lockheed 0.87 0.49

Average 0.42

business commercial ofweight

)business defense of(weight - UdefenseUcomposite

lUcommercia

18.10.503

0.42)(49.7%-0.80

lUcommercia

lUcommercia

What is ßU for commercial aircraft manufacturing business?

What is ßL for commercial aircraft manufacturing business?(assuming a D/E ratio of 20%)

1.38

0.250.34)-(11 1.18

E

D)T-(11

L

L

cUL

%3.16

%)4.5(38.1%82.8

)(

e

e

fmfe

r

xr

rrrr

Boeing cost of equity and WACC for 777(assuming increased leverage and hence increased cost of debt)

%3.14

%3.1680.0%0.1020.0)34.01(

)1(

WACC

WACC

rV

Er

V

DTcWACC

ED

Financial Risk - Risk to shareholders resulting from the use of debt.

Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt.

Interest Tax Shield- Tax savings resulting from deductibility of interest payments.

Capital Structure & Corporate Taxes

Capital StructureStructure of Bond Yield Rates

D

E

Bond

Yield

r

Weighted Average Cost of Capitalwithout taxes (traditional view)

r

DV

rD

rE

Includes Bankruptcy Risk

WACC

0% 10% 20% 30% 40% 50% 60%Debt Cost 7.0% 7.1% 7.2% 7.3% 8.0% 9.0% 11.0%Equity Cost 14.0% 14.1% 14.2% 14.5% 15.5% 17.5% 20.0%

WACC 14.0% 13.4% 12.8% 12.3% 12.5% 13.3% 14.6%

Gearing Ratio (Debt / Debt+Equity)

20.0%

14.5% 14.6%14.0%

12.3% 11.0%

7.0% 7.3%

5%

7%

9%

11%

13%

15%

17%

19%

0% 10% 20% 30% 40% 50% 60%Gearing

Cos

t

EquityCost

WACC

Debt Cost

European Telecoms 2003

Financial Distress

Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.

Market Value = Value if all Equity Financed

+ PV Tax Shield

- PV Costs of Financial Distress

Financial Distress

Debt

Mar

ket V

alue

of

The

Fir

m

Value ofunlevered

firm

PV of interesttax shields

Costs offinancial distress

Value of levered firm

Optimal amount of debt

Maximum value of firm