BACKGROUND As the world’s largest aerospace company and leading manufacturer of commercial jetliners and defense, space and security system, Boeing puts a lot of efforts and innovations in its products and services. These include commercial and military aircraft, satellites, weapons, electronic information and communication systems, and performance-based logistics and training. Due to customers’ needs and requests, Boeing has expanded its product line and services. The long tradition of aerospace leadership and innovation has given the company the advantages. Its broad range of capabilities includes creating new and more efficient commercial airplane, integrating military platforms and defense systems through network-enabled solutions; and arranging innovative customerfinancing options. Nowadays, Boeing, as the top exporter of U.S. and with its corporate offices in Chicago, supports airlines and U.S. and allied government customers in more than 90 countries. Besides, Boeing employs more than 159,000 people across United States and in 70 countries. In between, more than 123,000 of its employees hold college degrees, including nearly 32,000 advanced degrees, which means in virtually every business and technical field from approximately 2,700 colleges and universities worldwide. By the way, we can see how diversified, talented and innovated the workforces of Boeing company. Basically, Boeing is diversified into two business units: Boeing Commercial Airplanes and Boeing Defense, Space & Security. These two units are supported by three small units which are Boeing Capital Corporation, Share Services Group and Boeing Engineering, Operations & Technology. Each unit has its own duties. BOEING BUSINESS UNITS Boeing Commercial Airplanes Boeing Commercial Airplanes is being the leader in commercial aviation by offering airplanes and services that with characters of superior design, efficiency and value to customers around the world. In 1916, Boeing aviation pioneer, William Boeing, had built the company’s first airplane which is a seaplane for two with a range of 320 nautical miles. Since then, Boeing has defined the modern jetliner and introduced the twin-aisle cabin, the glass cockpit and countless other innovation. Moreover, in 1997, the merger of Boeing and McDonnell, gives the company a 70-year heritage of leadership in commercial aviation. Today, Boeing Commercial Airplanes, leads by James (Jim) F. Albaugh, offers a family of technologically advanced airplanes, mainly the 737, 747, 767 and 777 families of airplanes which can seat more than 500 and can boasts the longest range in the world, at more than 9,300 nautical miles. With headquarters in Renton, Washington, Boeing Commercial Airplanes continues with its new product development, a next-generation jet that will set the standard for fuel-efficiency and passenger comfort.
Boeing Defense, Space & Security Boeing Defense, Space & Security (BDS) provides large scale systems that enhance air-, land-, seaand space-based platforms for global military, government and commercial customers. BDS tries its best to provide customers with the right solutions at the right time and the right cost. Therefore, their strategy is to understand the enduring needs of customers and provide capability-based solution to meet their rapidly evolving requirements. In addition to designing, producing, modifying and supporting fighters, bombers, transports, rotorcraft, aerial refuelers, missiles, munitions and spacecraft for military, civil and commercial use, BDS also develops enhanced capabilities through network-enabled solutions, communication and intelligence, surveillance and reconnaissance technologies. In order to increase the efficiency, execution and capabilities of the company, the business is organized into five portions: Boeing Military Aircraft (in-charge of tactical and airlift aircraft, missiles, unmanned airborne systems, and surveillance and engagement programs), Global Services & Support (provides best-value mission readiness to its customers through total support solution), Network & Space Systems (provides information solutions, strategic missile and defense systems; network and tactical systems; satellites and other space and intelligence systems; and space exploration activities), Phantom Works (responsible for capabilities-based development and capture of advanced programs in support of the three Boeing Defense, Space & Security businesses) and Joint Ventures. Boeing Capital Corporation As a global provider of financing solution, Boeing Capital Corporation arranges structures and provides financing to facilitate the sale and delivery of Boeing commercial and military aircraft, satellites and launch vehicles. With a year-end 2009 portfolio of approximately $5.7billion, Boeing Capital Corporation combines Boeing’s financial strength and global reach, detailed knowledge of Boeing customers and equipment, and the expertise of a seasoned group of financial professionals. Engineering, Operations & Technology (EO&T) EO&T’s primary objectives are to support the company’s business units by delivering high-quality, low-cost technical services in information technology, research and technology, and test and evaluation; integrated enterprise strategies that ensure technology is ready when needed, competitively protected and environmentally progressive; and highly disciplined and efficient engineering, operations and supplier management support that ensures programs success. Besides, EO&T also enhances the growth and productivity of the company by driving technical and functional excellence across the enterprise. The organization pays attention to ensure the success of development programs, and strives to attract, develop and retain a world-class technical and functional work force. Shared Services Group
Shared Services Group helps business units to focus on profitable growth by providing the infrastructure services required to run their global operations. The group provides a broad range of services worldwide. For instance, facilities services, wellness program, disaster preparedness, reclamation, creative services and staffing construction. Furthermore, it also offers comprehensive travel services to Boeing employees and manages the sale and acquisition of all leased and owned property of Boeing. PRODUCT BOEING 7E7 After the highly successful launch of the Boeing 777 with United Airlines in June 1995, Boeing experienced a drought of novel commercial aircrafts for the next several years. So, later in 1990s, the 747X and Sonic Cruiser projects were cancelled due to insufficient market interest. As a result, in January 2003, the 7E7 project was announced. The leader of the 7E7 project is Michael Bair. Boeing hopes the 7E7 project will help it regain the commercial-aircraft sales that the company had lost over the years to Airbus. Boeing envisioned a higher-efficiency aircraft with lower operating costs to meet the needs of cashstrapped airlines in the midst of an unstable petroleum market. Through advancements in airframe design, jet engine technology, and the use of composite materials, the new 7E7 aircraft would also be more environmentally friendly than its predecessors. Although there was no official definition for the "E" in 7E7, it stood for "efficiency" or "environmentally friendly" to some. In July 2003, a public naming competition was held for the 7E7, for which out of 500,000 votes cast online the winning title was Dreamliner. The Boeing 7E7 was also expected to eventually be renamed the 787. The concept of Boeing 7E7 is driven by customer requirements. Base on the discussion with over 40 airlines throughout the world, Bair identified a fresh market to replace mid-size plane that could travel long distances and lower operating costs. Boeing was considering two new members for the 7E7 family, which are a basic and a stretch version. Boeing 7E7 Baseline Model The Boeing 7E7 baseline is a super-efficient airplane with new passenger-pleasing features. It will bring the economics of large jet transports to the middle of the market, using 20% less fuel than any other airplane its size. • Seating--- 200 passengers in three-class configuration --- 300+ in single-class configuration • Range--- 6600 nautical miles • Configuration--- twin-aisle • Cross section--- 226 inches • Wing span--- 186 feet
• Length--- 182 feet • Cruise speed---mach 0.85 • Cargo capacity after passenger bags--- 5 pallets + 5 LD3 containers • Program milestones--- authority to offer: late 2003/early 2004 --- assembly start: 2005 --- first flight: 2007 --- certification/entry into service: 2008 Boeing 7E7 Stretch The Boeing 7E7 Stretch is a slightly bigger version of the 7E7 Baseline. Both are super-efficient airplanes with new passenger-pleasing features. The Stretch will bring the economics of large jet transports to the middle of the market, using 20% less fuel than any other airplane its size. • Seating--- 250 passengers in three-class configuration --- 350+ in single-class configuration • Range--- 8000 nautical miles • Configuration--- twin-aisle • Cross section--- 226 inches • Wing span--- 186 feet • Length--- 202 feet • Cruise speed---mach 0.85 • Cargo capacity after passenger bags--- 6 pallets + 8 LD3 containers • Program milestones--- entry into service 2010 likely, but depends on marketplace. Now you ask, what's so special about the 7E7? The 7E7 will have a new cabin interior as well as new glass cockpit based on their very successful 777. To make the 7E7 as efficient as possible, the aircraft's complete design is different from all other aircraft types we've known up until now. The new production facility for the 7E7 will be based on the modular production method introduced by Airbus. With the 7E7 Boeing will open the door for a complete new range of aircraft, all of which will be based on the 7E7's design. New features on the 7E7 are a new wing design, which will be using a combination of the raked wingtip technology (767-400) and blended wingtips technology (BBJ/737NG). A new tail design and new engines are other revolutions on the 7E7, with the latter being the most important revolution. Boeing has announced it will chose between two engine manufacturers to be the sole providers of the engines for the 7E7. When developed these engines will be the most efficient engines yet. The 7E7 will carry 200-250 passengers on routes between 6,600 and 8,000 nautical miles (12,200 to 14,800 kilometers). The 7E7 will use 20 percent less fuel for comparable missions than any other wide body airplane. It will also travel at speeds similar to today’s fastest wide bodies, Mach 0.85. Another new technology is the health-monitoring systems that will allow the 7E7 to self-monitor and report maintenance requirements to ground-based computer systems. The wingspan is 57 meters, while the aircraft’s length will be 56 meters. The cargo capacity (besides the baggage) will be approximately 5 pallets and 5 LD3 containers. The maximum take-off weight (MTOW) will be 408,800 lbs (185,400 kg). A
proposed stretched version of the 7E7 will 62 meters in length, carry 6 pallets and 8 LD3 containers and have a maximum takeoff weight of 490,500 lbs. (222,400 kg). The baseline 7E7 will have 57 percent more cargo capacity compared to the Airbus A300-600. The stretched version of the 7E7 will have 44 percent more cargo capacity than the Airbus A330-200.
With the 7E7 programme, Boeing will also reinvent the structure of its supplier partnership. Included in this new relationship is the possibility of suppliers to purchase shareholdings in a special purpose company set-up to build the aircraft. Boeing will adopt the modular production approach used by Airbus, which transfers the production emphasis from the final assembly line to the sub assembly builders. Boeing has also secured joint technology development co-operations with three Japanese companies, Fuji, Kawasaki and Mitsubishi Heavy Industries of Japan. Other co-operations have been made with Alenia of Italy, GKN of the United Kingdom, Stork Fokker and Fischer of the Netherlands and Hawker de Havilland of Australia. With all these new technologies, the 7E7 may well be the next generation in aircraft manufacturing and development. Boeing has already indicated that with the 7E7 a new product line will be introduced at Boeing. We may see a complete new line of aircraft coming in the years ahead. Airbus has not announced any plans to develop a next generation A330 to compete with the 7E7. Airbus is still busy with their three latest products, the A340-500, A340-600 and moreover, their A380. Aircraft in Production or Development |Product list and details (date information from Boeing) | |Aircraft |Variants |Description |Capacity |First flight |Out of Production | | | | | | |Models | |737 |600, 700, 700C, 700ER, 800, |Twin-engine, single aisle, short-|85-215 |Apr 9, 1967 |100, 200, 200C, 200 | | |900, 900ER, BBJ, C-40, AEW, |to medium-range narrow-body | | |Adv, 300, 400, 500 | | |P-8 | | | | | |747 |8I, 8F, VIP, LCF |Four-engine, partial double |366-569 |Feb 9, 1969 |100, 100SR, 100B, | | | |decker, twin aisle main deck, | | |200, 200F, 200C, SP,| | | |single aisle upper deck, short | | |200M, 300, 300M, | | | |range (SR models), medium- to | | |300SR, 400, 400M, | | | |long- range widebody | | |400D, 400F, 400ER, | | | | | | |400ERF, VC-25, E-4 |
|767 |200ER, 300ER, 300F, 400ER, |Twin-engine, twin aisle, medium- |180-375 |Sep 26, 1981 |200, 300, E-767 | | |KC-767 Tanker |to long- range widebody | | | | |777 |200ER, 200LR, 300ER, Freighter|Twin-engine, twin aisle, medium- |301-550 |Jun 12, 1994 |None (July 2010) | | | |to long-range, ultra long-range | | | | | | |(200LR), large widebody | | | | |7E7 (787 |8, 9 |Twin-engine, twin aisle, |210-330 |Dec 15, 2009 |None (May 2010) | |Dreamliner) | |long-range widebody | | | | Interior of Boeing 7E7 Dreamliner The designation of Boeing 7E7 insures passengers comfort and quietness than any other jet. Inside ‘The Boeing 7E7 Dreamliner‘ have wider seats aishes, a spacious architecture, innovative LED lighting, big bins, more space and the largest windows. [pic] [pic] [pic] [pic] [pic] [pic] [pic] COMPETITORS 1) Airbus Airbus established in 1970 by a consortium of European companies, it took Airbus 23 years to deliver its first 1000 aircraft, another 6 years to deliver the next 1000 and only another 3 years (2002) to pass the 3000 aircraft milestone. Airbus is an aircraft manufacturing subsidiary of EADS (European Aeronautic Defense and Space Company N.V.). Airbus employs around 57,000 people at sixteen sites in four European Union countries: Germany, France, the United Kingdom and Spain. Final assembly production is at Toulouse (France), Hamburg (Germany), Seville (Spain) and, since 2009, Tianjin (People's Republic of China). Airbus has subsidiaries in the United States, Japan, China and India. The company is known for producing and marketing the first commercially viable fly-by-wire airliner, the Airbus A320, and the world's largest airliner, the A380. In 1999, for the first time in its history, it recorded more plane orders than its rival Boeing. Airbus’s large plane commercial aircraft products included the A300/310, A320, A330/340 and A380 family. Airbus touted the A300/310 family as having the flexibility to serve short, medium, and extended-range routes. The widebody twin-engine aircraft was considered midsize with a typical passenger configuration of about 250 passengers.
2) Lockheed Martin Lockheed Martinis is a United States aerospace, defense, security, and advanced Technology Company with worldwide interests. It was formed by the merger of Lockheed Corporation with Martin Marietta in March 1995. Lockheed Martin is among the very largest defense contractors in the world, and in 2008 70% of Lockheed Martin's employs 140,000 people worldwide and revenues came from military sales. Robert J. Stevens is the current Chairman and Chief Executive Officer. 3) Northrop Grumman Northrop Grumman is an American aerospace and defense technology company formed by the 1994 purchase of Grumman by Northrop. The company was the fourth-largest defense contractor in the world as of 2010. Northrop Grumman employs over 122,000 people worldwide. In January 2009, Northrop Grumman announced several structural actions to strengthen alignment with its customers, improve the company’s program performance and growth potential, and enhance its cost competitiveness. These actions included streamlining its organizational structure, reducing the number of sectors from seven to five. 4) Raytheon Raytheon Company is a technology and innovation leader specializing in defense, homeland security and other government markets throughout the world. Raytheon employs 72,000 people worldwide. With a history of innovation spanning 88 years, Raytheon provides state-of-the-art electronics, mission systems integration and other capabilities in the areas of sensing; effects; and command, control, communications and intelligence systems, as well as a broad range of mission support services. VALUATION OF PROJECT Market Demand In year 2002, The Boeing Company has been struggling with developing new aircraft to compete with Airbus' A330 and A340 which are doing very well and appears to be the best replacement for 767 operators. Because of this, Boeing is losing a lot of 757/767 customers to Airbus. This made Boeing decide to come up with an all-new aircraft featuring the more advanced technologies which is Boeing 7E7 to replace the 757, 767, A300 and even the successful A330 aircraft in early 2003.
With almost every U.S. major airline operating a large fleet of 757/767 aircraft, this will be the main target market for Boeing 7E7. These airlines may order or lease the 7E7 in the same numbers as their 757/767 fleets due to their close relationship with The Boeing Company and the commonality with their other Boeing aircraft. Besides this, Japan is also a potential market for Boeing 7E7 to enter into, for the reason that most of Japanese airlines are currently operate sizeable fleets of the 767 aircraft, which is also one of the series for Boeing’s aircraft. The Boeing 7E7 is a cost efficient plane that will use 20 percent less fuel compared to similarly sized aircraft types by using a more efficient engine and 10 percent cheaper to operate than Airbus’s A330-200. If it is successful, this will make the plane a potent competitor against the best-selling A330. In addition, the flexibility for short or long haul routes would allow airlines to offer non-stop service on routes and point-to-point travel to more destinations around the world. As shown in Exhibit 8 and Appendix, Boeing projected a demand for between 2000 and 3000 planes of the 7E7 type in the first 20 years, while the forecast analysis assume 2500 units of sales for years 1 through 20 and same unit of sales in years 20 for year 20 through 30. However, the demand was highly dependent on whether Boeing could deliver the promised 20 percent cheaper fuel costs and the range flexibility in a mid-size aircraft. Furthermore, if the range flexibility did require snap-on wings, such a design may significantly increase the cost to manufacture the 7E7. Those unknown variables will cause Boeing to face the engineering uncertainty of being able to deliver such an aircraft and also the risk of duplication by Airbus. The uncertainty of plane specification and risk of competition will put pressure on Boeing Company to the number of units that it would be able to sell. Market Share Airbus, the market leader, is the main competitor for The Boeing Company. In 2002, two companies, Boeing and Airbus, dominated the large plane (100+seats) commercial aircraft industry. While Boeing historically held the lead in this market, through a number of measures Airbus become number one. In 2002, Airbus received 233 commercial orders compared to Boeing’s 176 orders, representing a 57% unit market share and an estimated 53.5% dollar value market share. With the launch of Airbus A380 Super Jumbo, which has two decks and is capable of flying 550 passengers, the market share will have slightly a change which is better for Airbus. However, Boeing will be able to regain its market share with the model 7E7 and making the competition more aggressive. The Boeing 7E7 with lower operating cost and more fuel efficient is hoped to be a big hit to the airline industries and would outperform all the existing aircrafts. The 7E7 is designed to carry 200 to 300 people on routes from North America to Europe and Asia. Boeing designed this plane to fly long distances economically while keeping passengers comfortable and economizing on fuel. The other aspect of the 7E7’s success is the engineering of an expandable wing. Adding this versatility will give the 7E7 owner more options for travel routes. QUESTIONS
1. Why is Boeing contemplating the launch of the 7E7 project? Is this a good time to do so? When there is involving a decision of launching a project, we should consider many factors since it involves a large quantities of money. For Boeing, it should more concern on its project launching because the developing cost of the project could be as high as $10 billion. The huge initial cash outflows might require between one or two decades to recoup. Moreover, the pricing of product is subjected to competitive pressure, so it is unable to predict the payback period of the project. In addition, the board of directors wanted to keep the development cost of 7E7 down to only 40% of what it took to develop 777. Second, the technical support is also a factor that Boeing worries about. The major competitor of Boeing, Airbus, declared that 7E7 was a salesperson’s dream and engineer’s nightmare. Why do they say so? This is because 7E7 was claimed to be the first commercial aircraft that primarily build with carbonreinforced material which are stronger and lighter than traditional aluminum. However, the composite material was suspected as a contributory cause to a 2001 plane crash in New York. Therefore, regulatory scrutiny is needed. Moreover, the company promised to provide a jetliner which has the ability to travel long and short distance has also made engineering obstruction. Traditionally, two versions of plane with different wingspans are needed to make long and short distance travel. Boeing engineers considered the possibility of snap-on wing extensions which is more costly as well as technically feasible. In 2003, many incidents have occurred and made the airline profit the worst seen in generation. On February 1, China announced the breakout of SARS which the discovery of the deadly and contagious illness has subsequently spread to Canada and Australia. As of June 16, the travel warnings were still outstanding. Besides, the United States had gone to a war against Iraq in the March of 2003. The spam of global terrorism, the event of September 11, and the bursting of the technology bubble also led to a significant decline in airplane orders. All these incidents have caused consumers more focus on survival and not on speedy traveling. Another risk that should be considered is the competitive risk. Launch of new airplane, of course, will roll out a high success in the beginning but there is also risk for other competitors to duplicate the product. Airbus, the main competitor of Boeing, has stated that if the fuel efficiency was primarily generated by new engine designs, then it would simply order the more efficient engines for its plane. Therefore, the uncertainties in the 7E7 plane specifications and risk of competition clearly put downward pressure on both the price and unit sold that Boeing could demand. However, in long term, the profit for aircraft industry is feasible. This is because over the long term, the industry cycle will smooth out, international trade, lower fares and improvement of technology and network services will enhance the demand of aircraft. Boeing’s Market Outlook predicted that during the next 20 years, economies will grow annually by 3.2%, and air travel will continue its historic relationship with GDP by growing at an average annual rate of 1.5%. Therefore, the long term outlook of aircraft demand seemed positive.
At last, is it the right time to launch the 7E7 project? The answer definitely is “No”. However, in order to maintain its position in the aircraft industry, Boeing has to take the risk. 2. How would we know if the 7E7 project will create value? Net Present Value is the difference between the present value of cash inflows and the present value of cash outflows. It is used in capital budgeting to analyze the profitability of an investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield. NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, the project is in the status of discounted cash inflow in the time of t and it should be accepted. However, if NPV is negative, the project is in the status of discounted cash outflow in the time of t and the project should probably be rejected because cash flows will also be negative. In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected. |Whenever |NPV > 0 |NPV = 0 |NPV < 0 | |It means... |The investment would add value |the investment would neither |the investment would subtract | | |to the firm |gain nor lose value for the firm|value from the firm | |We will ... |Accept the project |be indifferent in the decision |Reject the project | | | |whether to accept or reject the | | | | |project. This project adds no | | | | |monetary value. Decision should | | | | |be based on other criteria, e.g.| | | | |strategic positioning or other | | | | |factors not explicitly included | | | | |in the calculation. | | Net present value for short term, 7E7 project is negative. However the long term outlook for aircraft demand seemed positive. Such as stated in page 234, Boeing’s Market Outlook said the following: Over the long-term, cycles smooth out, and GDP, international trade, lower fares, and network service improvements become paramount. During the next 20 years, economies will grow annually by 3.2% and air travel will continue its historic relationship with GDP growing at an average annual rate of 5.1%. 3. How to estimate the WACC? WACC = (Wdebt)(rd)(1-tc) + (Wequity)(re) Where, Wdebt = proportion of debt in a market- value capital structure rd = pretax cost of debt capital tc = marginal effective corporate tax rate
Wequity = proportion of equity in a market-value capital structure re = cost of equity capital From Exhibit 10, Debt/equity ratio=0.525 tc = 0.35 From page 237, Rf = 0.85% From Exhibit 2, Wdebt =44646/129686=0.344 Wequity = 85040/129686=0.656 From Exhibit 11, rd is calculated as below which is 5.335% |Debt amount |Price |Market value |YTM |Weighted YTM |202 |106.175 |214.474 |3.911% |0.167% |298 |105.593 |314.667 |3.393% |0.213% |249 |110.614 |275.429 |3.475% |0.191% |175 |112.650 |197.138 |4.049% |0.159% |349 |129.424 |451.690 |5.470% |0.492% |597 |103.590 |618.432 |4.657% |0.573% |398 |127.000 |505.460 |6.239% |0.628% |300 |126.951 |380.853 |5.732% |0.435% |247 |114.506 |282.830 |6.047% |0.341% |249 |131.000 |326.190 |6.337% |0.412% |173 |138.974 |240.425 |5.805% |0.278% |393 |103.826 |408.036 |5.850% |0.475% |300 |106.715 |320.145 |6.153% |0.392% |100 |119.486 |119.486 |6.173% |0.147% |173 |132.520 |229.260 |5.777% |0.264% |125 |110.084 |137.605 |6.191% |0.170% |Total: |5022.119 | |5.335% |
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The cost of equity capital (re ) will be calculated using CAPM. Thus, re = Rf + β*E(Rm) - Rf] Risk free rate + Equity Beta * (Expected return on market - Risk free rate) Risk premium=8.4% Since Boeing has two business components (defense and commercial), βBoeing=βcommercial* Wcommercial + βdefense*Wdefense In order to calculate equity beta, we use the information given in Exhibit 10. Risk is inherent in the economy and equity markets and the 60 trading day Boeing BetaEquity calculated against the NYSE Index would be a most accurate predictor of future risk. Due to the length of the Boeing project, at first glance it would appear a beta calculated using a longer regression period would estimate future returns best. BetaAsset =BetaEquity /[1+(1-tc)D/E]
NYSE 60 trading days estimated BetaEquityBoeing =1.62 Market-value debt/equity ratio = 0.525 BetaAsset = 1.62/[1+(1-0.35)0.525] = 1.21 The comparison to Lockheed Martin and Northrop Grumman is the most responsible since we are given the equity betas and percentage of revenues derived from government (defense and space). Lockheed Martin and Northrop Grumman is the closest competitor to being a pure defense contractor, Exhibit 10 indicates the percentage of revenues derived from government for Lockheed Martin and Northrop Grumman is 93% and 91% respectively, which will help access the best estimate for beta asset of defense. NYSE 60 trading day BetaEquityLM for Lockheed Martin = 0.37 Debt/equity ratio for Lockheed Martin = 0.410 Betaasset defense = 0.37/[1+(1-0.35)0.41] = 0.29 S&P500 60 trading day BetaEquityNG for Northrop Grumman=0.30 Debt/equity ratio for Northrop Grumman = 0.640 Betaasset defense = 0.30/[1+(1-0.35)0.640 = 0.21 Average beta of defense = 0.25 From Exhibit 10, Boeing Rev from Defense (Wdefense) = 0.46 Boeing Rev from Commercial Sales (Wcommercial) = 0.54 βBoeing= βcommercial* Wcommercial + βdefense*Wdefense 1.21 = βcommercial *0.54+0.25*0.46 βasset commercial =1.095/0.54= 2.03 βequity commercial =2.03*1+(1-0.35)0.525=2.72 re = Rf + β*E(Rm) - Rf] =0.85%+2.72(8.4%) =23.70% WACC = %debt (rd)(1-tc)+ %equity(re) =0.344*0.05335*(1-0.35)+0.656*0.2370 =16.74% 4. Is there anything else the board of directors should consider in assessing the financial appeal of this project? Why might the board vote ‘yes’ on the 7E7, when the cost of capital estimate is greater than the IRR? Why might the board vote ‘no’ if the cost of capital is less than the IRR?
In assessing the financial appeal of The Boeing 7E7 project, there are three criteria that need to fulfill before determine the acceptance or rejection of this project, which are included all cash flows that occur during the life of the project, consider the time value of money and incorporate the required rate of return on the project. To determine whether to accept or reject The Boeing 7E7 project, the board of directors can use several methods such as Payback Period, Discounted Payback Period, Profitability Index, Internal Rate of Return and Modified Internal Rate of Return to evaluate the project. Payback Period The payback period is the length of time, usually expressed in years, required to recover the initial outlay in the project. It measures how long will it takes to earn back the money that spent in the project. The basic premise of payback period is the projects with shorter paybacks are more liquid and less risky which allow the board of directors to recoup their investment sooner, so that they can reinvest the money elsewhere. Many firms use the payback period as an investment evaluation criterion and method of ranking projects. They compare the project’s payback period with a predetermined payback period. The project would be accepted if the payback period is less than or equal to the firm’s maximum desired payback period. Advantages • Easy to calculate and understand • Adjusts for uncertainty of later cash flows • Biased toward projects with higher liquidity Disadvantages • Ignores the time value of money • Ignores cash flows beyond acceptable payback date • Requires an arbitrary cutoff point Discounted Payback Period The discounted payback period is similar to the payback period method but instead of using cash flows it considers the payback of discounted cash flows. It is because the simple payback period has the problem of ignoring time value of money, whereby the money received today is more valuable than receive in the future because of inflation, uncertainty, and opportunity costs. Discounted payback period is an investment decision rule in which cash flows are discounted at an interest rate and one determines how long it takes for the sum of the discounted cash flows to equal the
initial investment. The board of directors can use it to make a decision regarding whether to take on The Boeing 7E7 project. It basically calculates the time it would take for a project to generate enough cash inflow to break even, taking the time value of money into consideration. The project should be accepted if its discounted payback period is less than a specified cutoff period. Advantages • Easy to calculate and understand • Considers time value of money • Biased toward projects with higher liquidity Disadvantages • Ignores cash flows beyond acceptable payback date • Requires an arbitrary cutoff point • Biased against long-term projects, such as R&D and new products Profitability Index (PI) The profitability index or benefit/cost ratio is the ratio of the present value of the future free cash flows to the initial outlay. It provides a measure of an investment proposal’s desirability – that is, the ratio of the present value of its future benefits to its initial cost. It also a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment. Profitability index is a useful tool for companies to rank the possible investment projects but since companies usually have limited financial resources, they only invest the most profitable projects. If there are a number of possible investment projects available, the company can use the profitability index to rank those projects from the highest profitability index to the lowest to decide in which to invest. If profitability index is one or more, then project should be accepted but if profitability index is lower than 1.0, they will have to think of other investment opportunities. Advantages • Considers time value of money • Considers all cash flows • Closely related to NPV, leading to same decision most of the time Disadvantages • Requires detailed long-term forecasts of a project’s free cash flow • May lead to incorrect decisions in comparisons of mutually exclusive investments Internal Rate of Return (IRR)
The internal rate of return is simply the rate of return on an investment that equates the investment outlay with the present value of cash inflow received after one period. This also implied that the rate of return is the discount rate which makes net present value equal to zero. Internal rates of return are commonly used to evaluate the desirability of investments or projects. The higher a project's internal rate of return, the more desirable it is to undertake the project. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first. If the IRR is greater than or equal to the required rate of return, the project should be accepted but if its IRR is less than the required rate of return, the project should be rejected. Advantages • Considers time value of money • Considers all cash flows • Easy to understand Disadvantages • Possibility of multiple IRRs • Requires detailed long-term forecasts of a project’s free cash flow • May lead to incorrect decisions in comparisons of mutually exclusive investments Modified Internal Rate of Return (MIRR) The modified internal rate of return (MIRR) is basically same as the internal rate of return (IRR) for a project except for one factor. IRR assumes the cash flow from an investment or project to be reinvested at the IRR, whereas MIRR assumes that all cash flows to be reinvested at the investor’s or firm’s cost of capital. With this reason, the MIRR is said to reflect the profitability of a project or investment more realistically than an IRR. The modified internal rate of return is the discount rate that equates the present value of the project’s cash outflows with the present value of the project’s terminal value, where the terminal value is defined as the sum of the future value of the project’s free cash flows compounded to the project’s termination at the project’s required rate of return. Same with IRR, the project would be accepted if the MIRR is greater than or equal to the required rate of return and the project would be rejected if the MIRR is less than the required rate of return. Advantages • Considers time value of money • Considers all cash flows • No longer possible to get multiple answers Disadvantages
• Requires detailed long-term forecasts of a project’s free cash flow • Still lead to incorrect decisions in comparisons of mutually exclusive investments Cost of Capital VS Internal Rate of Return The cost of capital can be defined as a firm’s required rate of return, the hurdle rate for new investments, the discount rate for evaluating a new investment, and the firm’s opportunity cost of funds. It is a rate that must be earned on an investment project if the project is to increase the value of the common stockholder’s investment. While internal rate of return (IRR), as described above, is simply the rate of return on an investment that commonly used to evaluate the desirability of investments or projects. According to the IRR Rule, the company should accept the project when the IRR is greater than the cost of capital and reject the project when the IRR is less than the cost of capital but it only be applied to those project having conventional cash flows. However, in practice, a firm’s project does not always have conventional cash flow streams. Non-conventional cash flows are possible and the decision rule is different from that conventional cash flows. Non-conventional cash flows mean that the signs of cash flows change more than once. For example, if the signs of cash flows for a 5-year project from year 0 to year 5 are –, +, +, +, +, –, means the signs change two times. It is possible occur to Boeing 7E7 project as the project requires a large amount of expenditures to end the project. The decommissioning costs will bring the negative cash flow to a firm at the end of a project’s life. In this case, there might be more than one IRR where the NPV is zero. The IRR decision rules that stated the project would accepted if the cost of capital is less than IRR is seem to be misleading because the project should only be accepted if the cost of capital is between IRR1 and IRR2. The NPV approach avoids this problem quite simply. By using the cost of capital as the discount rate in the NPV formula, a negative NPV is generated if cost of capital is less than IRR1, a positive NPV is obtained if cost of capital is between IRR1 and IRR2, and the NPV is negative again if cost of capital is greater than IRR2.This cause the board might vote ‘yes’ on the 7E7, when the cost of capital estimate is greater than the IRR and vote ‘no’ when the cost of capital is less than the IRR. Another reason that may cause such decision is because The Boeing 7E7 is a long term project and required huge expenses to launch it. So, it may need to take a longer period to maximize the profit and cover the expenses. If not, the board of director will lose their money that already invested in the project. They will choose to continue the project even the cost of capital is greater than IRR. The cost of capital also known the weighted average cost of capital (WACC) as calculated above is 16.74%. If compared to internal rate of return (IRR) which is 15.7% as shown in Exhibit 9, the calculated WACC is greater than the IRR. As a result, the board of director may vote ‘yes’ on the Boeing 7E7 project when the cost of capital estimate is greater than the IRR. 5. What should the board do?
The board should approve the launch of the Boeing 7E7 Project. There are, however, inherent risks in this project resulting from the design and materials used. The 7E7 is the first plane to use a carbon body construction and employ wingtip extenders. This will add risk to the project since they have never been used on such a large scale project. Airbus is a close competitor. They will be coming to market with their new A380 in 2005. This plane will be a formidable competitor to the 7E7. If Boeing falls behind regarding innovation, fuel efficiency and all the other attributes of a long haul airliner they will lose their market share. In order for Boeing to compete in the aviation industry, they must take on some risk and develop this new plane. With the economy so volatile, airlines will be looking for options that reduce their operating costs. The 7E7 will carry more passengers per flight in a fuel efficient manner allowing the airline companies to justify purchasing the plane. The success of the expandable wing will also give the plane attractive versatility. The equity market risk premium should equal the excess return expected by investors on the market portfolio. In this case it was calculated to be 8.4%. The weighted average cost of capital (WACC) was calculated to be 17.8%. Since the projected revenues listed in Exhibit 8 are “well behaved” we can trust the IRR tables in Exhibit 9. For the project to increase shareholder wealth, the IRR of the project should at least equal the WACC. To achieve this Boeing would have to sell at least 2500 airliners in a 20year period. Boeing is expecting to reach this unit goal. The financial calculations provided in this report show that there is a very good chance that the project will increase the wealth of the shareholders. There are other risks mentioned above that must be considered but on balance the reasons to go forward with the project outweigh those against it. REFERENCES Airbus. Retrieved from Wikipedia: http://en.wikipedia.org/wiki/Airbus Boeing 787 Dreamliner. Retrieved from History of the Boeing 7E7 and 787: http://www.squidoo.com/boeing787 Cannegieter, R. Boeing 7E7: Launching a new generation. Aerlines Magazine, 28, 1-3. Chen, J.-H. (2008, September). Finding multiple internal rates of return for a project with nonconventional cash flows: Utilizing popular financial/graphing calculators and spreadsheet software. College Teaching Methods & Styles Journal, 4, 31-42. Keown, A. J., Martin, J. D., Petty, J. W., & Scott, D. F., Jr. (2005). Financial management: Principles and applications (10th ed.). New Jersey: Prentice Hall, Inc. Lockheed Martin. Retrieved from Wikipedia: http://en.wikipedia.org/wiki/Lockheed_Martin Northrop Grumman. Retrieved from Wikipedia: http://en.wikipedia.org/wiki/Northrop_ Grumman
Raytheon. Retrieved from Wikipedia:http://en.wikipedia.org/wiki/Raytheon
