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Advanced Finance Project Spring 2012 The Boeing Company Mark Kettlewell

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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 the market, 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 Boeings 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.

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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 firms 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 allequity financing which I believe is a mistake given Boeings 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

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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 Lines 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).

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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, Boeings 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 Boeings 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 Boeings 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).

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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 Boeings 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 Lines 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.

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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 Boeings 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. Boeings 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 fuelefficient 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. Its easy to set targets like these, but engineering new technology often takes longer than anticipated. Its essentially invention on a schedule.

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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 Boeings 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. Boeings 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

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Source Data and Calculations on Boeings Long Term Debt

Coupon Rate (%) 3.5 4.875 5 1.875 6 5.125 6.875 3.75 5.875 6.125 8.75 7.95 6.625 7.25 8.75 8.625 7.875 6.875 7.5 4.75 6 4.85 4.65 5.6 5.8 5.6 5.5 5.7 5.65 4.75 % of Debt 8.17% 8.97% 7.59% 7.12% 8.14% 6.27% 7.34% 5.58% 5.82% 5.06% 5.40% 4.54% 4.21% 3.33% 3.43% 2.67% 2.83% 1.65% 1.42% 0.14% 0.08% 0.07% 0.05% 0.04% 0.02% 0.02% 0.02% 0.02% 0.02% 0.00% Cost of Debt Weighted YTM 6.86% 20.91% 9.42% 9.11% 18.64% 8.02% 30.15% 8.25% 24.38% 21.82% 23.22% 14.12% 17.63% 13.76% 19.60% 12.45% 12.33% 8.21% 7.03% 0.14% 0.05% 0.08% 0.03% 0.03% 0.07% 0.02% 0.02% 0.12% 0.04% 0.02% Market Value 805.5 885 749 702.1 802.75 618 723.5 550 573.75 499.2 532.524 447.6 414.9 328.5 338.5 263.55 278.95 162.25 139.7 13.7148 7.432294 7.26752 4.88642 3.57236 2.254938 1.87272 1.8162 1.604784 1.633957 0.442976

Name Boeing 3.5% Boeing 4.875% Boeing 5% Boeing 1.875% Boeing 6% Boeing 5.125% Boeing 6.875% Boeing 3.75% Boeing 5.875% Boeing 6.125% Boeing 8.75% Boeing 7.95% Boeing 6.625% Boeing 7.25% Boeing 8.75% Boeing 8.625% Boeing 7.875% Boeing 6.875% Boeing 7.5% Boeing Cap Corp Internotes 4.75% Boeing Cap Corp Internotes 6% Boeing Cap Corp Internotes 4.85% Boeing Cap Corp Internotes 4.65% Boeing Cap Corp Internotes 5.6% Boeing Cap Corp Internotes 5.8% Boeing Cap Corp Internotes 5.6% Boeing Cap Corp Internotes 5.5% Boeing Cap Corp Internotes 5.7% Boeing Cap Corp Internotes 5.65% Boeing Cap Corp Internotes 4.75%

Maturity Date 2/15/2015 2/15/2020 3/15/2014 11/20/2012 3/15/2019 2/15/2013 3/15/2039 11/20/2016 2/15/2040 2/15/2033 8/15/2021 8/15/2024 2/15/2038 6/15/2025 9/15/2031 11/15/2031 4/15/2043 10/15/2043 8/15/2042 5/15/2013 5/15/2012 5/15/2013 6/15/2013 7/15/2012 6/15/2012 7/15/2012 6/15/2012 6/15/2012 6/15/2012 11/15/2013

Amount in Millions 750 750 700 700 650 600 500 500 450 400 398 300 300 250 250 175 175 125 100 13.2 7.366 6.988 4.676 3.53 2.226 1.836 1.8 1.608 1.591 0.436

Price 107.4 118 107 100.3 123.5 103 144.7 110 127.5 124.8 133.8 149.2 138.3 131.4 135.4 150.6 159.4 129.8 139.7 103.9 100.9 104 104.5 101.2 101.3 102 100.9 99.8 102.7 101.6

YTM 0.84 2.33 1.24 1.28 2.29 1.28 4.11 1.48 4.19 4.31 4.3 3.11 4.19 4.13 5.71 4.66 4.36 4.99 4.96 1.04 0.69 1.02 0.7 0.87 2.93 1.16 1 7.23 2.24 3.86

Total Market/book Ratio

8118.257 1.214764816

2.87 %

9861.77

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Capital Asset Pricing Model

1.96% beta 1.05 12.79% Expected Return 13.43%

Dividend Growth Model

g Expected Rate of Return

1.68 72.56 4.33% 6.74%

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

equity Equity Long Term Debt assets

$ $ $

1.05 54,109,498,563.28 12,169,513,924.41 0.86

Equity Calculation Number of Shares Outstanding Share Price Total Market Value (Equity)

745,720,763.00 72.56

$ 54,109,498,563.28

Appendix C

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Capital Asset Pricing Model WACC calculations

WACC [= RA] = wD x [RD x (1-T)] + wE x RE Equity Market Value Bond Market Value Corporate Tax Rate Cost of Equity Cost of Debt Weight of Equity Weight of Debt Total Market Value Weighted Average Cost of Capital $ $ 54,109,498,563.28 12,169,513,924.41 35.00% 13.43% 2.87% 81.64% 18.36% 66,279,012,487.69 11.30%

WACC calculated using Dividend Growth Model

WACC [= RA] = wD x [RD x (1-T)] + wE x RE Equity Market Value Bond Market Value Corporate Tax Rate Cost of Equity Cost of Debt Weight of Equity Weight of Debt Total Market Value Weighted Average Cost of Capital $ $ 54,109,498,563.28 12,169,513,924.41 35.00% 6.74% 2.87% 81.64% 18.36% 66,279,012,487.69 5.85%

Asset Beta Calculation

beta

1.96% 0.86 12.79% 10.96%

Expected Return

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Hybrid WACC Calculation

DGM Cost of Equity CAPM Cost of Equity Average 6.74% 13.43% 10.09%

WACC [= RA] = wD x [RD x (1-T)] + wE x RE Equity Market Value Bond Market Value Corporate Tax Rate Cost of Equity Cost of Debt Weight of Equity Weight of Debt Total Market Value Weighted Average Cost of Capital $ $ 54,109,498,563.28 12,169,513,924.41 35.00% 10.09% 2.87% 81.64% 18.36% 66,279,012,487.69 8.58%

Boeings Earnings Yield Since 1998

P/E 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 37.6 18.6 17.1 18.6 14.1 33.4 29.4 26 22.2 17.9 18.3 24.1 14.7 14.5 Mean ROE Dividend Earnings per share Retention Ratio Sustainable growth rate 2.66% 0.56 1.15 51.30% 1.36% 5.38% 0.56 2.19 74.43% 4.00% 5.85% 0.59 2.84 79.23% 4.63% 5.38% 0.68 2.79 75.63% 4.07% 7.09% 0.68 2.82 75.89% 5.38% 2.99% 0.68 1 32.00% 0.96% 3.40% 0.85 1.63 47.85% 1.63% 3.85% 1.05 2.39 56.07% 2.16% 4.50% 1.25 3.62 65.47% 2.95% 5.59% 1.45 5.26 72.43% 4.05% 5.46% 1.62 3.63 55.37% 3.03% 4.15% 1.68 1.87 10.16% 0.42% 6.80% 1.68 4.46 62.33% 4.24% 6.90% 1.68 4.82 65.15% 4.49% 5.00% Average SGR 3.10%

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Dividend Geometric Growth Data

beginning year 0.55 1996

Ending Year

Geometric mean 1.68 7.73% 2011

0.55 0.59 0.64 0.69 0.74 0.80 0.86 0.93 1.00 1.07 1.16 1.25 1.34 1.45 1.56 1.68 1.81 1.95 2.10 2.26 2.44 2.63 2.83

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

0.59 0.64 0.69 0.74 0.80 0.86 0.93 1.00 1.07 1.16 1.25 1.34 1.45 1.56 1.68 1.81 1.95 2.10 2.26 2.44 2.63 2.83