Two Business Segments and Main Problems

            BOEING 7E7 PROJECT

                                                                                Group Members: Yuxin Tian

                                                                                                             Jiannan Wu

                                                                                                             Yiwen Zhang

                                                                                                             Andong Song

                                                                                                             Chujun Li

                                                                                Date:Oct.20th, 2018

Two Business Segments and Main Problems

The Boeing Company is the world’s largest aerospace company and its main business activities include manufacturing commercial aircrafts, defense, space and security systems, and service providing of aftermarket support to more than 150 countries. Its two primary segments are commercial aircrafts and integrated defense system, each   accounts for about half the net revenue of Boeing. The defense system business that cooperating with government is more stable, and the commercial aircrafts segment is volatile to changing market.

Recently, the main problems Boeing facing with are: 1) the entire market is experiencing a recession, so the demand for commercial aircraft is declining； 2)the customers requirement and preference are changing for those and other reasons，which are difficult to follow and satisfy； 3)the competitive threat from Boeing’s chief competitor Airbus is increasing，and Boeing is losing money because Airbus takes delivery orders from Boeing. Boeing has to figure out some ways to regain the lost market share.

The Dilemma of 7E7 Project

For the September 11 attack, SARS and Iraq War etc., the whole aircraft industry is declining. Some ongoing projects of Boeing were interrupted, like well-known “Sonic Cruiser”, and huge initial R&D investment became sink cost. Boeing eagerly needs a new successful project to rescue itself from financial difficulty.

The 7E7 project is a turning point. It is created under the customers’ demand, and it is equipped with many innovative functions, which will improve operating efficiency and reduce operating cost. Also, it will satisfy customers’ up－dated requirements like safety and economy consideration. So in current position, once launched, 7E7’s future should be promising.

However, Boeing is still contemplating the launch of 7E7, for by now Boeing is not sure about the following questions. Considering its passive price power and sales volume forecast, whether the 7E7 project will be profitable? How long will 7E7 project take to recover the extensive initial R&D expense? As for the difficult stage for the entire industry, what is the best time point to launch this project? It seems necessary to make a detailed valuation analysis of the 7E7 project to support the final decision.

Capital Budget Decision        

When deciding whether a project is appropriate to pursue, the capital budgeting decision tools will be helpful. The most common tools are payback period, net present value method and internal rate of return method. To evaluate the 7E7 project, we choose to use the internal rate of return method (IRR).

Although the payback period is the most basic and simple one, it serves better for small and simple investment projects to calculate how long it will take the company to receive back the initial investment. However, the Boeing company put as high as $10 billion to develop the 7E7 project, and the project did not have positive cash flow until its sixth year after launching. It seems that the investment cannot be recouped in a few short years. Therefore, the payback period is not a highly effective way to evaluate this project.

Compared with the payback period, the net present value tool is more common and effective in evaluating large firms or projects. However, the net present value, which needs to discount those future cash flows back to the present value, is an absolute measure, it cannot directly indicate the return rate of the project. In addition, it is easily affected by the market interest rate and cannot reflect the project’s real profitability.

The IRR is a useful metric utilized by business. We accept the project when the IRR is higher than the discount rate and reject it when the IRR is lower than the discount rate, which is simple to apply. It is straightforward when we calculate independent projects. Therefore, we do not need to consider external influences. While the IRR cannot work if cash flows exhibit two changes of the sign during the investment period, there is only one change of cash flow sign in the 7E7 project, so we can just get only one result of IRR. Besides, as a relative measure, the IRR can directly indicate the yield of the project when compared with the industry benchmark.

In conclusion, we consider IRR as the best capital budgeting decision rule to evaluate the 7E7 project.                

Discount Rate

We first divide the Boeing company into 2 different segments, commercial aircraft business and integrated defense systems business, since these two kinds of business have different features. We find out that the higher percentage of revenue from integrated defense systems, the lower beta the company will get, and we assume that it is because commercial aircraft business is riskier than government defense.