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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
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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?
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%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
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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
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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?
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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?
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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
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%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
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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
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Capital StructureStructure of Bond Yield Rates
D
E
Bond
Yield
r
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Weighted Average Cost of Capitalwithout taxes (traditional view)
r
DV
rD
rE
Includes Bankruptcy Risk
WACC
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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
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European Telecoms 2003
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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
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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