Boeing 747 Case Study

Case Summary

1. In early 2003, Boeing announced plans to design and sell an airliner named the 7E7. Boeing aimed for the 7E7 to be more fuel-efficient, carry between 200 and 250 passengers, able to accomplish both domestic and international flights, as well as be 10% cheaper to operate than Airbus’s A330-200 aircraft.

All of these attributes were attractive to Boeing but would come at significant costs. To accomplish these attributes, Boeing proposed to construct the aircraft primarily out of carbon-reinforced material, add a more fuel-efficient engine, use of composites to reduce manufacturing costs, and be assembled in 3 days. There were also some obstacles standing in Boeing’s way of making this aircraft. For this aircraft to be able to accomplish both domestic and international flights, the engineers said they would need two different planes with different wingspans. The second obstacle was Boeing’s board of directors.

With the 7E7’s project costs planned to be $10 billion, there was an imminent veto threat if the project costs could not be decreased by billions. The board wanted more specifically to keep the 7E7’s development costs down to 40% and per copy costs down to 60% of the 777 aircraft costs. Boeing’s CEO and chair, Philip Condit, knew that if Boeing did not take risks, their days of being a competitor in the commercial-aircraft industry were numbered.

2. In 2002 the large plane commercial-aircraft industry is dominated by two big competitors; Boeing and Airbus.

Although Boeing had historically held the largest market share, Airbus started closing in. In 2002, Airbus received 233 commercial orders compared to Boeing’s 176. This had Airbus representing a 57% market share and an estimated 53. 5% dollar value market share. While Airbus concentrated on passenger aircraft, Boeing’s operation has two main segments: commercial airplanes and integrated defense systems. In 2002, Boeing was awarded a $16. 6 billion defense contract. Boeing’s operations had seen revenue falling in the commercial aircraft segment but saw their defense revenues rising.

The defense contract gave Boeing a chance to use some of their technology research for both commercial and defense aircraft. Boeing’s commercial-aircraft is comprised of six airframes designed for short, medium, and long-range travel. As of December 31, 2002, Boeing undelivered units from under firm order of 1083 commercial aircraft and had a declining backlog of about $68 billion. With all of the canceled orders, Boeing was predicting 280 commercial-aircraft deliveries in 2003, which would bring revenues down to $22 billion in 2003 from $28 billion in 2002.

Realizing the effects the economy was having on the airline industry, Boeing decided to cut production rates in half in order to maintain profitability in that segment.

Boeing 7E7 Financial Plan

1. The 20-year forecast of free cash flows for the Boeing 7E7 project has some strict implications. The 7E7 project would have to yield an internal rate of return close to 16%, Boeing would be able to deliver the promised plane specifications, and that Airbus wouldn’t be able to reproduce the 7E7 efficiencies.

The base case assumes that Boeing would be able to sell 2500 units within the first 20 years of delivery. Pricing for the 7E7 was a hybrid between the prices of Boeing’s 777 and 767. Since the capacity of the 7E7 was between that of the 777 and 767, it was possible to estimate the value placed on the range and number of passengers. The cost of a base 7E7 would be $114. 5 million and a stretch 7E7 would be $144. 5 million. The prices of the 7E7 were assuming that customers would pay a 5% premium for the lower operating costs. The internal rate of return of 15. % is sensitive to variations in the underlying assumptions. The biggest uncertainty being that Boeing would be able to sell 2500 units and at the desired prices. There were also some unknown variables that needed to be taken into account. Development and per-copy costs were the costs that the board wanted to minimize. The forecast assumes that development costs would be $8 billion. There was great uncertainty surrounding the manufacturing cost of the 7E7. The element that adds the most uncertainty to the manufacturing costs is in the engineering of the aircraft.

While the engineering costs could be high, Boeing was hoping that the lower construction costs of using the composite materials would compensate for the elevated engineering costs.

2. The cost of capital for Boeing would hinge on several factors.

Factors such as beta and the debt/equity ratio for Boeing and other companies in the same industry could impact how much Boeing’s cost of capital could be. The marginal tax rate for Boeing was expected to be around 35%. Yields on three-month Treasury bonds were. 85% and the yield on 30-year Treasury bonds was 4. 56%.

On June 16, 2003, Boeing’s stock closed at a price of $36. 41. An important factor in figuring Boeing’s cost of capital would be that Boeing was separated into two different businesses. The defense business was more stable due to the declaration of war against Iraq while the commercial business was more volatile due to the events of September 11, 2001. Due to the fact of Boeing being divided into two different businesses makes calculating the cost of capital and the required rate of return difficult.

3. The risk premium is the excess return that an individual stock or portfolio of assets provides over the risk-free rate.

This higher return compensates investors for taking a higher risk. This premium will vary based on the amount of risk that is being undertaken. Since the risk of the commercial aircraft industry is relatively high, we are expecting a risk premium high enough to compensate Boeing’s shareholders. We rounded up the expected rate of return to 13% and we subtracted the risk-free rate of 4. 56%, which gave us a risk premium of 8. 44%.

4. Beta would a measure of risk or volatility of an individual security or portfolio in comparison to the market.

With all of the risks facing the commercial sector of Boeing’s business, the beta would be high to reflect these risks. While the events of September 11, 2001, the outbreak of the SARS virus, and the war in Iraq are not typical events. Although these events are not typical, they may be reflected in the beta of Boeing’s commercial sector to be higher than it really should be. To calculate the beta, we found that the Boeing 60 trading days calculated against the NYSE was 1. 62 and the market value of the debt/equity ratio was 0.525. To find Boeing’s beta we took 1. 62/(1+. 525) which gave us 1. 62155.

Main Problems

1. One of the problems for Boeing, in this case, is will the 7E7 project compensates the shareholders for the use of their capital. There are many unknown variables that Boeing will need to consider. Some of the factors that need to be considered are things that Boeing cannot control such as aircraft demand, a competitive marketplace, and other factors. Aircraft demand plays a big part in Boeing’s plans for 7E7. If demand for the 7E7 is low or plummets, they will not be able to meet their goal of manufacturing 2500 units within the first 20 years of delivery.

While the commercial-aircraft has only two large competitors, the threat that Airbus could come up with an aircraft to rival the 7E7 is a good possibility. If Airbus were to build an aircraft similar to the 7E7, this would push the prices of the planes down and once again force Boeing to not be able to meet their goals. Although Boeing seemed to have most of the 7E7’s project assumptions in place, there were some factors that Boeing was not able to quantify. Engineering costs and building costs were the two things that Boeing was unsure how much both of them would cost.

Building costs could be estimated but engineering costs were the main concern because there was no real approximation of how much they could be.

2. The second question Boeing needs to consider is what kind of impact will the economy have on its plans for the 7E7 project. Many of these things are also out of Boeing control but need to be considered. A number of these instances were outlined in the case such as the terrorism attacks on September 11, 2001. After this incident, many passengers were skeptical about the safety of flying.

With passengers choosing other ways to get to their destinations Boeing would have to figure this into their analysis of whether to go forward with the 7E7 project. Another event was the outbreak of SARS. Since SARS was easily contagious and deadly, people were postponing or canceling their travel plans which would affect Boeing’s returns. With the introduction of the Iraq war in the Middle East, this would not be one of the places that travelers would want to be visiting. All of these factors would be things that Boeing would have to think about and consider if the timing was right for the 7E7 project.

3. The last problem would be dealing with ethical considerations. The time horizon of the 7E7 project is 30 years and although the ages of Boeing’s management are not given, we are inferring that most, if not all, of Boeing’s current management, will have retired by the point the project is completed. Boeing’s management could be using this project as a way to raise their compensation. If management can get the 7E7 project approved by the Board of Supervisors, they can possibly raise compensation for themselves based on the fact that the new project got approved.

Even though the project could get approved, that doesn’t mean it will be a success.

Analysis and Conclusion

The main question is, is this an attractive project to undertake? According to the data. The 7e7 at its present NPV and its IRR of 15. 66, by selling 2500 in the first 20 years the IRR would take the NPV down to zero. So Boeing would have to be able to sell 2500 and no less. The 7e7 would also have to deliver on its promise to lower operating costs if it is to be acceptable. By keeping the cost of shares down it will increase the power of its market shares.

This may be an important factor is in a down economy, if the economy does not rebound quickly. An example of a down economic state may be the decrease in demand after September 2011. Finally, if any additional increases in costs by selling the plane are incurred it could bring down the NPV into a negative which is not very attractive. In conclusion, the critical factors in determining if this project will have positive cash flows are its cost of goods sold, the number of deliveries in years, and development costs.

They are the most sensitive in their effect on NPV. The cost of goods sold needs only a 3% decrease, the number of deliveries a year about 15% decrease and a 10% increase in development costs will cause the NPV to become negative. There is too small of a cushion between positive and negative cash flows. Another factor that greatly affects the NPV is any delays to the startup of the project. If by any chance the company were to delay the project by more than 3 years the project would lose much of its positive cash flows.

These following assumptions do cause concern but based on the historical the original assumptions draw from, we deduced that historical fluctuations were not volatile enough to reach negative levels of NPV. The WACC used for these valuations came from the commercial industry of Boeing and adjusted for the extra risk that the WACC of Boeing as a whole does not account for. Therefore we do expect that this project will be accepted and should be accepted by the NPV model. This analysis was done with one WACC with a beta derived from a 60-month trading day beta from the NYSE.

Other Betas should be considered when looking into the valuation as they produce different results. In this report, we only focused on one Beta but in our analysis, we did compute several other Betas. Our conclusion from the different Betas was that with Beta’s with shorter trading days the WACC would become significantly higher and would result in negative Betas from the original assumptions. Any adjustment to the assumptions would have to be done with the notion of valuing the project higher to produce a positive NPV. Though with our first WACC, we accepted the project, the same would not be said for all scenarios.