Alexis Heideck ● Eduardo Lioy ● Jonas Angeles Keya Williams ● Ritwik Malvi

Case Overview

•

Boeing

• World’s leading manufacturer of commercial jet aircraft • • • • Historical 54% market share 2 principal segments: defense & commercial aircraft Sales of $27 Billion and expected profits of $1.4 Billion in 1990 50% profit increase from 1989 • • • Main competitors: Airbus Industries & McDonnell Douglas Oct 1990 = CEO, Frank Shrontz announces Boeing 777 launch Shrontz’s mission: Raising Boeing’s ROE of 12%

Case Overview

• • • •

Boeing 777

• 350-390 Passengers • • • • • International travel Can travel up to 14000 kilometers First delivery in May 1995 $130 million per plane Fastest growing market segment (seats & distance) Expected increase in airline traffic of 5.2% over next 15 years Forecasted 10.6% growth in traffic to Asia

Kuwait Invasion

• Political & economic uncertainties • Increase in oil prices and decline in airlines travel

Profitability Measures

• Improving ROE = Accounting measure of increasing shareholders wealth • • • To improve ROE: • a) Increase Net Income • b) Reduce Total Book Equity • Better measure is CF to shareholders (dividends, capital gains). 777 contribution to CF is relevant.

According to projected cash flow: • Negative cash flow: First 5 yrs (decrease in ROE) • Projected positive cash flows for remainder of project If Boeings projections hold 777 project will significantly increase Net Income, ROE.

Why Is The 777 Important?

• Meets market need for medium to large

aircraft

• • 5.2% annual increase in airline traffic by 2010 350-390 passengers; travels up to 7600 miles • Expected sales of 1000 Units in first 10

years

• Sales price of $100-$130 Million • Most Flexible and Cost efficient • Fly by wire technology

SWOT Analysis

Strengths

• Boeing has a 50% market share

Weaknesses

• $97 Billion in backorders on aircrafts • • Carry up to 390 passengers ; 7600 miles • Only firm order received by United Airlines • Fly by wire technology Estimated savings in R&D spending of 20% • Large capital expenditures on manufacturing facilities and training (estimated $2.5 Billion) • Involvement from engineering and airlines to ensure customer satisfaction • Folding wing tip technology • Estimated 10-20 Years to break even • Risks of depleting book value of equity if not successful

SWOT Analysis

Opportunities Threats

• Annual Increase in Airline traffic of 5.2% . 10.6% in Asian market • Competition in niche market (Airbus Industries and McDonnell Douglas) • Aging Aircrafts - Replacement value of 642 large aircrafts • Competition may cause decrease in price ($130M to $100M) • Unknown length of war • Unstable political and economic climate • Increase in oil prices – decrease in airline travel and cancellation of orders

Determine Boeing’s WACC

To determine the appropriate WACC we used following formula:

r WACC

= E V

r

e

quity

+ D V

r debt

 ( 1 -

t

) And followed a stepwise approach: (1) Calculate Boeing ’ s commercial aircraft division b (2) Calculate Boeing ’ s Cost of Equity (3) Calculate Boeing ’ s Cost of Debt (4) Calculate Boeing ’ s WACC

Boeing’s Commercial Aircraft Division

b • Reference market portfolio selection • S&P 500 selected (Boeing listed in S&P 500, index represents a close group of peer large cap US companies) • Reference time interval selection • 12 months β selected because : • 12 months data reflects current market conditions.

• • 58 month data would provide an outdated picture 60 days data strongly biased by short term fluctuations.

Boeing’s Commercial Aircraft Division

b • Calculate unlevered and Lockheed). b ’s for three “pure play” defense aviation companies (Grumman, Northrop b unlevered = b levered debt 1 + (1 t) equity % Revenues From Defence S&P 500 12 Month Beta Levered Market-Value D/E Tax Rate 1+ (1-T)* D/E Beta Unlevered Defense division

Grunman

0.87

Northrop

0.89

Lockheed

0.85

0.73

1.756

0.34

2.15896

0.338

0.72

1.288

0.34

1.85008

0.389

0.69

1.182

0.34

1.78012

0.388

Average Beta for Defense for All 3 Defense Companies 0.372

Boeing’s Commercial Aircraft Division

b • Re-lever the average b to reflect Boeings capital structure and obtain Boeings defense division b.

• b defense = b

unlevered

   1 + (1 t) debt equity   = 0 .

372  ( 1 + (1 0.34)  0.018

) =

0

.

376

Calculate Boeings commercial aircraft division b using following relationship: b Boeing = % defense  b

defense

+ % commercial  b

commercial

b

commercia

l = 1.719

Determine Cost of Equity

• From Boeing’s defense division b we can calculate the cost of equity using the Capital Asset Pricing model.

• R isk free rate = 8.82 % (long-term U.S Treasury Bonds) • Market risk premium = 5.4% (64 year geometric average equity-market risk premium)

r

e

quity

=

r free

+ (

r market

-

r free

)  b

commercial

= 0 .

0882 + ( 0 .054)  1 .

719 = 18 .

10 %

Determine Cost of Debt

• • • Estimate cost of debt using market rates of Boeing’s corporate bonds. Boeing’s long-term debt consist entirely of two bond issues Calculate weighted average of the market rate these two issues to arrive at a combined r

debt

:

r debt

= V bond1 V bond 1 + 2 

r bond1

+ V bond2 V bond 1 + 2 

r bond

2

r debt

= 234.5

234 .

5 + 37  0 .0973

+ 234 .

37 5 + 37  0 .

0931 = 9 .

67 %

Weighted Average Cost of Capital (WACC)

•

r WACC

= E

r

e

quity

V + D V

r debt

 Insert values for r

debt

, r

equity

equity and debt proportions: and the relative

r WACC

= 14896.76

14896.76

+ 271.5

 18.10% + 271.5

14896.76

+ 271.5

 9 .

67 %  ( 1 0 .

34 ) = 17 .

89 %

r WACC

= 17 .

89 %

Impacts of Economic Climate and Impending War

Long Term Impacts • β is a weighted sum of β’s for each division: • Changes in revenue from each division will affect β of each division • Factors affecting Commercial Division’s β: • Long-Term economic growth due to war spurring commercial air travel • Factors affecting Defense Division’s β: • Increased demand for and spending on defense products by government due to war

Impacts of Economic Climate and Impending War

Short Term Impacts • Events in Kuwait led to increase in fuel prices • Increased expenditure for airlines leads to price increases for customers • Temporary dip in passenger air traffic • Temporary decrease in demand for Boeing’s commercial division • Since the Boeing 777 project is 35 year long project, long-term impact is more relevant

Revenue/Cost Scenarios & Project Profitability Key Assumptions

• Key Assumptions Impacting Cash Flow: • • • Revenue Assumptions: Sales Price Sales Volume • • • Expenditure Assumptions: R&D (as % R&D Expense / Sales) GS&A (as % GS&A Expense / Sales)

Revenue/Cost Scenarios & Project Profitability Sensitivity Analysis

Revenue Assumptions: Sales Volume and Sales Price

Extreme Low Expected Extreme High

Sales Volume (Units) 700 1000 1200 Sales Price ($ Millions) $100 $130 $130 IRR 13.9% 18.9%

WACC = 17.894 %

20.6%

Revenue/Cost Scenarios & Project Profitability Sensitivity Analysis

Expenditure Assumptions:%R&D/Sales and %GS&A/Sales

Extreme Low Expected Extreme High

% GS&A/Sales 7 4 1 % R&D/Sales IRR 5 3 13.5% 18.9%

WACC = 17.894 %

1 23.5%

Revenue/Cost Scenarios & Project Profitability Assumptions and Real World Forces

• Revenue Assumptions: PESSIMISTIC Impact • • Sales Price: McDonnell Douglas/Airbus Industries competition (Sales Price = $100M) Sales Volume: High gas price reduces demand to 700 units • Expenditure Assumptions: OPTIMISTIC Impact • • R&D: Boeing could leverage defense knowledge (R&D reduced by 20% = $3.2-$4M or 2.6% R&D Expense/Sales) GS&A: None specified, assume at baseline (GS&A = 4%)

Revenue/Cost Scenarios & Project Profitability

Revenue Assumptions: Pessimistic • • Pessimistic Sales Price = $100M Pessimistic Sales Volume = 700 units

Pessimistic Price Only Pessimistic Volume Only

Sales Volume (Units) 1000 700 Sales Price ($Millions) $100 $130

Pessimistic BOTH

700 $100

Expected

1000 $130 IRR 16.1% 16.3% 13.9%

WACC = 17.894 %

18.9%

Revenue/Cost Scenarios & Project Profitability

Expenditure Assumptions: Optimistic • • Optimistic %R&D Expense/Sales = 2.6% Optimistic assumes baseline GS&A at expected = 4% Optimistic %R&D Expense/Sales

Expected

% GS&A/Sales 4 4 % R&D/Sales IRR 2.6

3 19.5%

WACC = 17.894 %

18.9%

DCF Analysis of Boeing 777

•

DCF Analysis supports Boeing 777 Project

• IRR = 18.9 % (expected case)

>

WACC = 17.894 % • Real World Forces may impact Key Assumptions, however some Pessimistic Forces likely Short Term • Revenue Assumptions – PESSIMISTIC • Expenditure Assumptions – OPTIMISTIC

DCF Analysis of Boeing 777

• Limitations of DCF Method • Static Model Static assumptions projected for entire project – unrealistic • • • • • • Real World Factors create uncertainty in modeling: External Threats (including competitive landscape) Interaction/Interdependence of divisions/projects on one another Organizational Learning/Efficiency, Reduced Expenses Over Time Sunk Costs • • •

The Boeing 777 Case Specifically:

Competition and sales Organizational learning and R&D expense Ignores sunk costs of R&D expenses prior to October 1990

Recommendations

• Continue to innovate and invest • Need to update fleet and replace aging products • Decide which investment is correct: • Boeing’s 777 fills a gap and serves a fast-growing Asian market • 777 project IRR’s range from 13.6% (pessimistic) to 23.6% (optimistic) while discount rates range from 10% - 20% • Project IRR exceeds baseline discount rate • The above data supports the strategic advantages of investing in the Boeing 777 launch

Alexis Heideck ● Eduardo Lioy ● Jonas Angeles Keya Williams ● Ritwik Malvi