Boeing 7e7

BOEING 7E7 Case Analysis Report Introduction Boeing is an American multinational corporation that manufactures and provides commercial jetliners, military aircrafts, satellites, weapons, communication system and other military platforms and defense systems. It is also the one of the largest defense contractor in the world. Boeing focused on the research and development to provide excellent and unique specification of aircraft that no one can replicate. In 1994, Boeing 777 had been highly successfulin the commercial aircraft industry. After few years, it cancelled its two programs. One is the “Sonic Cruiser “which promised to fly 15% to 20% faster than any other commercial aircraft. It was cancelled due to insufficient market interest. The passengers were not willing to pay premium price for a faster ride. In 2003, airline profits had declined due to war of US and Iraq, global terrorism and the spread of deadly disease called SARS. In the same year, Boeing 7E7 was announced by Michael Blair, the leader of the 7E7 project. This aircraft has the capacity of 200 to 250 passengers that could travel both short domestic and long international flights. It would use less fuel, incur cheaper operating costs and has long or short distance flexibility that would attract customers at the right price. It would be the first commercial aircraft built primarily with carbon-reinforced material which was stronger and lighter than traditional aluminum. It was also said that it would use composites to reduce manufacturing costs. However, it has risk. Composite materials were suspected as contributory cause to a 2001 plane crash in New York. 7E7 were subsequently called “Dreamliner”. For Airbus, its chief rivalry, it was called as “salesperson’s dream and engineer’s nightmare”. And since it has the capability for long distance flights, it would need a Snap-on wing extension. However, it was very costly. The cost of the project could be high as $10 billion and there was an imminent veto threat if the cost did not shrink by billions. Boeing and Airbus dominated the large plane (100+ seats) commercial aircraft industry. Historically, Boeing lead in the said industry while for a number of measures, Airbus became the number one. Airbus was its main competitor. It already recorded more plane orders than Boeing. In 2006, A380, a superjumbo four-engine jet, had been scheduled to fly with a 550-passenger configuration and long distance range up to 8000 miles. It would be the largest passenger aircraft ever built! The Boeing Company has two primary segments namely commercial airplanes and integrated defense system. The major rivalry in the defense system was Lockheed Martin. Nevertheless, Boeing was awarded $16.6 billion defense contract last 2002. The company’s defense revenues were rising while commercial aircraft revenues were were declining. For commercial aircraft segment, there were two kinds of models designed to meet the needs of every customers. These are the standard and wide-body models. On the other hand, the demand for commercial aircraft was influenced by business cycles, consumer confidence and exogenous events n short term. For long term, the GDP, international trade, low fares become paramount. Eventually, the company had been considering the two members of 7E7 family, base and stretch version. These two have different specifications. The Stretch version is much larger than baseline version and it has longer distance to travel. Before the plan can be started, Blair should need to complete a valuation of the project and prove to the board if the 7E7 project would be profitable for the company’s shareholder. Statement of the Problem Michael Bair, the leader of the 7E7 project, introduced the new aircraft to the board. And presenting this new project to the board required him to create a financial analysis regarding this project. The following are the main problems found in the case: 1. How would Bair estimate the weighted-average cost of capital? 2. Should the board approve the 7E7?

Cacatian, Amabelle | Pastolero, Mae Ann | Prado, Keziah Mace | Elijay, Joshua Christian

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Porter’s Five Forces Model

Threat of New Entrants

Bargaining Power of Suppliers

Rivalry Among Competitors 4 3 2 1 0

Threat of Substitutes

LEGEND 0 No threat to the business 1 Insignificant threat to the business 2 Low threat to the business 3 Moderate threat to the business 4 Significant threat to the business 5 High threat to the business

Bargaining Power of Buyers

Threat to New Entrants | LOW Because of the presence of mainly two large companies in the industry, the threat to new entrants in very low. Competition between Boeing and Airbus has been considered as a duopoly. This resulted from a series of mergers within the global aerospace industry, with Airbus beginning as a European consortium while the American Boeing absorbed its former arch-rival, McDonnell Douglas in a 1997 merger. Other manufacturers, such as Lockheed Martin and Convair in the United States and British Aerospace, Dornier and Fokker in Europe, were no longer in a position to compete effectively and withdrew from this market. The industry also requires high research and development costs and production costs. It can be concluded that the new competitor that is planning to enter the market will eventually lost because the market has been penetrated already by the two giant companies. Bargaining Power of Suppliers | LOW With a high number of available suppliers worldwide, the aircraft industry’s bargaining power of suppliers is relatively low. Since there are only two basic companies in the industry, the suppliers consider them as their primary consumers. Bargaining Power of Buyers | MODERATE Anecdotal evidence on the widespread use of price discounts and favorable financing options suggests that aircraft companies compete in prices. As an example, a Harvard Business School case study reports significant underbidding between Boeing and Airbus, and cites the former Airbus Chairman Alan Boyd admitting to “pricing for f or market share...we had to do it in order to t o get our feet in the door.” Yet price competition might be a questionable assumption during the periods when firms face capacity constraints. Tyson (1992) reports that the industry sources claim that capacity constraints were not binding during the 1980s. Threat of Substitute Products | LOW There is no considered substitute product for aircrafts. If it will be compared to a ferry, both have different functions and uses. Aircrafts are being used for air navigation while ferries are for sea travelling. Airline companies would not have any an y choice but to get their aircrafts from either Boeing or Airbus. Air bus. Rivalry among Competitors | SIGNIFICANT There are two basic key players in the aircraft industry. The industry possesses greater competition because industry players are equal in size and power, and therefore compete for market dominance. The industry also requires higher fixed costs and will require firms to compete to be able to gain the largest amount of market share possible to cover the fixed costs. The industry has already slowed down in terms of growth and has already reached the maturity stage of the industry life cycle; therefore, increasing the competition for higher market share and increasing profit growth. The two players also compete in terms of pricing. During 2001, Airbus having an approximately 55% market share has surpassed Boeing, with 45% because of re-organization. Due to the presence of primarily two large companies in the industry, the rivalry among competitors is significant.


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SWOT Analysis Strenghts           

It has dominated the large plane plane (100+ seats) commercial-aircraft commercial-air craft industry. industry. It focuses on the R&D for aircrafts and the defense system. system. It occupies a large market share. It is competent in terms of excellence and efficiency of the products. It produced aircrafts designed to meet the needs of the short to long range markets. It has several business segments such as commercial commercial aircrafts and defense system. system. 7E7 projects will use less fuel, incur lower operating costs and has has long and short distance flexibility. 7E7 would be the first commercial aircraft built primarily with carbon-reinforced carbon-reinfor ced material which was stronger and lighter than traditional aluminum. 7E7 provides flight entertainment, internet internet access, health monitoring and so on. on. Defense revenues are rising. The use of composites would reduce manufacturing costs.

Weaknesses       

It requires large initial cash outflow It cannot easily charge customers for premium prices so the two programs including Sonic Cruiser were cancelled. Airbus, its main competitor, recorded more orders and lead the commercial aircraft market. The demand is subject to short-term, cyclical deviations. It was not able to deliver 1083 commercial aircraft and had declining backlog of about $68 billion. The board wanted wanted to keep 7E7 development costs down to only 40% of what I took to develop 777. The GDP will grow for the next 20 years.

Opportunities     

It could offer more routes at cheaper prices. It could produce more types of aircrafts that has unique specifications to remain competitive. It could focus on its other business segments when the demand for commercial aircrafts is weak. It should have continuous R&D and innovations. Based on estimation, there will have more than than 400 city pairs for nonstop flight of 7E7.

Threats      

There is an imminent veto threat if the development costs of $10 billion did not shrink by billion. There is a risk on the composite materials. There is a close competition with Airbus for commercial commercial aircraft and Lockheed Martin in defense contracts. External events such as US-Iraq war, global terrorism and SARS may affect the operations as well as revenues. There is a risk that Airbus may replicate the unique specifications of aircrafts. There is a threat on its revenues due to events in September 11 and bursting of technology technology bubble.

Alternatve Courses of Action 7E7 or “Dreamliner” is a promising project with a concept that is customer -driven. -driven. With a higher performance and fuel efficiency, the new aircraft is very commendable. Also, this will position Boeing in the market and may possibly regain the taken market share by Airbus. And just j ust like in releasing any new product line, a proper timing should be guaranteed to ensure success. However, in this case, external and uncontrollable factors are making things worse for 7E7 such as the fear for global terrorism, SARS, and the weak financial condition of airlines.


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To help the board in deciding whether to accept or reject the project, the weighted-average cost of capital is computed that will be compared to the IRR. Calculating the WACC Determining the Cost of Equity

To compute for the WACC, the cost of equity component is first estimated using Capital Asset Pricing Model (CAPM). However, estimating the beta is the first concern in this case. Since there are two segments for Boeing (commercial aircraft and defense), it is deemed appropriate to use different betas for these two segments as inputs to the CAPM. An explanation for this is that the segments bear different risks and using one beta to represent the other is faulty and can result to improper estimation. Another concern for this case is the proxy of the market portfolio and the fitting time interval. Between the two indices (S&P 500 and New York Stock Exchange), the NYSE has a higher value index. And ideally, ideall y, this is a better measure. Addition Addit ion to this, Boeing is listed on NYSE; therefore, t herefore, the t he estimation estim ation of beta is based on this index. As for the time interval selection, 60-day period is used since this already includes the Iraq war and the peak of the SARS illness. The 60-day beta of 1.62 is more appropriate than the other two because it reflects the current market condition; meanwhile the 21-month beta will mirror the 9/11 event which has hugely affected the stock and the 60-month data is already too long to be used as a basis. There are series of betas mentioned in the case; and to get the defense beta, similar firms such as Lockhead Martin and Northrop Grunman data are used. The average unlevered betas of these two firms are used as the asset beta of the defense segment. Then, to determine the beta of commercial aircraft segment, the weights of commercial airplanes and integrated defense system are obtained by using the revenue as a basis of computation. The beta of the commercial segment is computed following this formula: () ) 

[( () )  (  )( )(   )  )]  ()

Using the formula above, the computed unlevered commercial aircraft beta is 2.03. Using the Hamada equation, this beta is levered which is 2.72. Based on the yield for a 30-year U.S. treasury bond of 4.56% as risk-free rate, 74-year market risk premium in geometric mean of 4.70%, and the levered commercial aircraft beta of 2.72, the cost of equity amounting to 17.34% can be computed (see table 3). Determining the Cost of Debt

Getting the weighted average of all available debt information is made to estimate the cost of debt. In this case, individual yield-to-maturity (YTM) rate of all the outstanding bonds of the Boeing Company as of June 2003 are proportioned to its market value over the total market value to get the weighted yield-to-maturity. These weighted yield-to-maturity rates are then totaled which is used as the cost of debt. As for the tax rate, theoretically, theoreticall y, the expected m arginal tax rate is utilized instead i nstead of the historic al, average tax rate. Thus, it is more appropriate to use the marginal effective tax rate of 35% as the case notes. Determining the Debt and Equity Weights

Market values are used in determining the capital structure weights. In this case, the market value of debt and equity ratio is already given – given – 0.525. 0.525. From this, the market values of debt and equity can be algebraically derived, having 34.4% and 65.6% respectively. Estimating the WACC

Using all the inputs mentioned above, the WACC will result to 12.56%.


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Recommendation Based on the data computed, it can be recommended that the board should approve such project. As a general rule for Internal Rate of Return (IRR), the company should accept a project if the IRR is greater than the Weighted Average Cost of Capital (WACC). The WACC can be a measure of required rate of return and discount rate for new investment evaluation. If the IRR is greater, it means thatsuch investment project is earning more than what is required by the company. However, it is inevitable for the company not to take any risks because unexpected ones may just suddenly appear and affect all significant decisions in the company. In relation to sales price and volume, if both of them are substantially low like only 1500 units were sold at 0% price premium, IRR will now be less than the WACC which may lead to rejection of Boeing 7E7. Also when Cost of Goods Sold and development costs will be significantly high, same negative decision may also arise. Operational inefficiencies may arise, which can increase costs and affect profit. In order to prevent such things from happening, the board should improve their risk management by first establishing milestones regarding the investment project. They should monitor its development and progress, and quickly change anything that is causing problems. But through the given data in the case exhibits and estimates by the analysts, financial calculations in this paper heavily states that there is a good probability that the project will be a success and will increase the value of the company and wealth of stockholders. Being a company committed to be engaged in the commercial airplane industry, it is of no doubt that the board will be urged not to think twice in approving Boeing 7E7. Huge potential benefits can be gained if the project will be successful. So in approving the project, the board should also take into consideration how to act carefully and properly so that the company would not suffer any losses due to weak risk management being conducted.


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Appendix Table 1 – Unlevered Betas Lockhead Martin

Northrup Gorman

Boeing

Tax Rate

35%

35%

35%

Market Value Debt/Equity Ratio

0.41

0.64

0.525

60-Day Equity Beta based on NYSE

0.37 0.29

0.3 0.21

1.62 1.21

Beta (unlevered) Table 2 – Weights of Segments Revenues Commercial Airplanes

$

Integrated Defense Systems

28,387 24,957

Others

725

Total

$

54,069

Commercial Airplanes

54%

Integrated Defense System

46%

Table 3 – Cost of Equity 2.72

βLevered, Commercial

30-Year Treasury Bond (Rfr )

4.56%

74-Year Equity MRP (Geometric Mean)

4.70% 17.71%

Cost of Equity Table 4 – Cost of Debt

Debt Amount ($)

Price ($)

Market Value ($)

YTM

Weighted YTM

202 298 249 175 349 597 398 300 247 249 173 393 300 100 173 125

106.175 105.593 110.614 112.650 129.424 103.590 127.000 126.951 114.506 131.000 138.974 103.826 106.715 119.486 132.520 110.084

214.474 314.667 275.429 197.138 451.690 618.432 505.460 380.853 282.830 326.190 240.425 408.036 320.145 119.486 229.260 137.605

3.911% 3.393% 3.475% 4.049% 5.470% 4.657% 6.239% 5.732% 6.047% 6.337% 5.805% 5.850% 6.153% 6.173% 5.777% 6.191%

0.167% 0.218% 0.191% 0.159% 0.492% 0.573% 0.628% 0.435% 0.341% 0.412% 0.278% 0.475% 0.392% 0.147% 0.264% 0.170%

Total

5,022.12


5.340%

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Table 5 – WACC Weight for Debt

34.43%

Weight for Equity

65.57%

Cost of Debt

5.340%

Cost of Equity

17.34%

WACC

12.56%


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Boeing 7e7

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