Boeing Analysis

Provide a brief overview of the relevant issues and summarize your recommendations.

In early 2003, Boeing announced its plans to develop a new airplane (7E7 & 7E7 Stretch) in a market that was facing a tight squeeze on profits. The decline in the airline industry was attributed in large part to the war in Iraq, international terrorism, and fear of spreading SARS. The development of this new aircraft could possibly bring Boeing out of their innovation slump and potentially give them an advantage in the mid-sized aircraft market.

Since 1994, Boeing had not put a new airplane into production and had failed to follow through on two commercial aircraft programs. The company was in desperate need of an aircraft that would set them apart from Airbus, their main competitor and market leader. Boeing’s vision for the 7E7 was a cost efficient plane that used less fuel, had cheaper operating costs, and flexibility for short or long haul routes. The new plane would be made with cheaper composite parts which would reduce the production time from 20 days to 3 days.

The new project faced some concerns. The cost efficiency relied on the use of composite materials that had not gained regulators’ confidence. Also, Boeing would have to design completely new production methods for this new plane. Unfortunately, Boeing has a track record of problems with their production methods and delivering planes on time. The board of directors also expected development cost estimates to be substantially reduced prior to approving such a product. The demand in the market was for cheaper and more efficient planes, and that ideology needed to be part of Boeing’s development strategy.

Airbus, the market leader, produced planes to serve the short, medium and extended-range routes. Analysts believe that Airbus seemed to be more bullish on the future of the large aircraft market leaving Boeing an opportunity to gain back market share in the mid-size market, assuming that Airbus did not pursue the mid-range segment with a competing product. Boeing had a drop in commercial airplanes delivered from 527 in 2001 to 381 in 2002 and needed this project to keep them in the hunt with Airbus.

The board will also have to consider the decades it may take to recoup the costs of starting this project. Development costs in the airline industry are substantial leading to many years of negative cash flows. The introduction of a new plane is a make-or-break activity for the producers and requires huge financing capabilities. The development costs and per-copy costs were difficult to predict, and Boeing also faced engineering uncertainty with the project. The success of the project depends heavily on Boeing’s ability to keep the production costs low and actually deliver a more efficient aircraft than the competition.

A final consideration that needs to be evaluated is the set up of the Boeing business. It is set up as two separate businesses- the integrated defense systems business and the commercial business. The defense systems group experienced significant revenue growth due to the war and demand from fear of terrorism. As stated previously, the aircraft division is experiencing an uncertain market. Analysts believe that Boeing has significant technology advantages because of the transferability of R&D across the two divisions. One question to consider, should the required return be based on the two business portfolios or by individual division?

Recommendations summarized:

Ultimately Boeing needs to determine if the project will be profitable and if it will have positive cash flows in accordance with business requirements. Our analysis shows that the WACC, NPV and IRR are favorable (according to sensitivity analysis) and the project will likely be profitable. Boeing should keep this project as an individual project within the commercial business division. Defense projects and commercial projects both have unique factors that can be handled efficiently through separate divisions with the ability to share research and knowledge between the two divisions. Boeing should pursue the project with disciplined focus on maintaining cost efficiencies.

What is the project’s estimated WACC?

Cost of Debt

To calculate the average cost of debt, we took a weighted average of all interest rates on outstanding bonds of The Boeing Company as of June 2003. The weighted average bond YTM interest rate was 5.286% (see chart using Boeing case exhibit 11 data below). Next, we multiplied by (1-Tax Rate), which resulted in an after-tax cost of debt of 3.436%.

Cost of Equity

Since the case study does not mention preferred stock issues, we assumed that there were none.

To estimate the cost of common equity, we used the CAPM approach: rs = rRF + (RPM)bi:

RRF=4.56%(Treasury bond rate listed on page 7 of the case)

RPM=6.40%

bi = 1.05 (We used the Value Line beta listed on page 23 of the case since it consisted of the most data, 5 years, in comparison with the New York Stock Exchange Composite Index)

Using the CAPM approach, the cost of equity is 11.28%.

Capital Structure

The market value debt/equity ratio given in Exhibit 10 of the case is 0.525. We assumed that this ratio reflects Boeing’s capital structure target and that Boeing will finance the 7E7 commercial aircraft project equal to the firm’s capital structure (i.e. using only debt and equity). If so, then only slightly more than a third of the 7E7 project will be financed through debt, with the rest coming from equity as shown below:

D/E = 0.525

D+E = 1 пÑ" D = 1-E пÑ" (substituting back into first equation) пÑ" (1-E)/E = 0.525

пÑ" E = 1/1.525 = 0.6557 and therefore D = 1-0.6557 = 0.3443

Weighted Average Cost of Capital

WACC = wdrd(1-T) + wprp + wcrs

OR

WACC = (% of debt)(After-tax cost of debt) + (% of preferred stock)(Cost of preferred stock) + (% of common equity)(Cost of common equity)

WACC = .3443(3.436%) + .6557(11.28%)