Case Study Solution
Introduction/ Case Summary:
The Boeing Company is an Industrial Aircraft Design and Manufacturing Firm, diversified in its offering of products for both the Defense Industry and the Commercial Airline Industry. In October 1990, CEO Frank Shrontz has announced the launch of a new product, the Boeing 777. A medium-to-large passenger aircraft, the 777 would enable the flexibility to carry passenger loads ranging from 350-390 passengers, over distances up to 7600 nautical miles. Already, Boeing has received orders from United Airlines, with delivery expected in May 1995 (p. 198). Aside from the technological advances represented in the 777, the launch of this new product promises some potential distinct strategic advantages. The launch of the 777 would provide a medium-to-large aircraft, filling a gap in Boeing’s total passenger aircraft product line. Boeing would now have a complete suite of aircrafts capable of addressing passenger loads ranging from 100-500. The 777 is specifically targeted to service routes in a high growth segment of the market, influenced heavily specifically by the high growth rate of the Asian market. The following is a financial analysis of the anticipated launch of the 777 product line. The analysis includes a comprehensive quantitative financial analysis of the projects profitability along with a qualitative analysis of the strategic importance of the project in the economic and political context of the time and an assessment of how those key factors can impact the profitability of the project. Also offered are global recommendations regarding the Boeing 777 project, given the results of financial analysis and the consideration of other key factors.
Profitability measures and the Boeing 777 project
Return on Equity (ROE) is a commonly used profitability measure; according to the case, maximizing ROE is also a key objective of Boeings CEO Frank Shrontz. ROE is defined as the ratio between net income and total equity; it is an accounting measure of how well stockholders fared during the year. By improving the ROE, shareholders’ wealth would be increased. Therefore, it appears that Frank’s goal of improving Boeing’s ROE is in line with that of increasing shareholders’ wealth.
However, accounting book values are significantly impacted by the firm’s accounting practices, and what is really relevant for the shareholders are actual cash flows to stockholders. As such, the key measures from the stockholders’ wealth perspective are dividends and stock value (dividend gains and capital gains). In order to really increase shareholders’ wealth, the company’s equity (the stock) needs to provide a return higher than the opportunity cost of capital that could be earned elsewhere on the capital market for an investment of comparable risk.
The Boeing 777 Project may contribute to an improvement in net income and ROE if, over time, total revenues generated by the project exceed total cost and the resulting returns from the investment are higher than Boeing’s opportunity cost of capital. In other words, the 777 Project will improve shareholder’s wealth as long as the NPV of its cash flows is positive (as long as the IRR is greater than the opportunity cost of capital).
If Boeing’s revenue and cost forecast in Exhibit 6 is accurate (1000 planes sold over 10 Years at $130M per plane), the 777 Project would deliver an IRR of 18.9%; thus, shareholders’ wealth would be increased as long as the relevant opportunity cost of capital is <18.9%.
Strategic relevance of the Boeing 777 project
The 777 project is important because it fulfills a market need for a medium to large aircraft which carries 350-390 passengers over 7,600 miles. With airline traffic expected to increase by 5.2% annually from 2005, this presents a key opportunity for Boeing to grow its commercial airline business and increase revenue. Boeing estimates that 75% of all aircraft sales will be in this market segment, and if it maintains a 50% market share, it will sell 1000 units for $130 million each by 2005. Production costs will be high initially but will decrease over time. Another key aspect of the 777 project is related to the strategic need to respond to the competitor’s aggressive plan to launch airliners in the same segment.
3.1 SWOT Analysis:
Boeing is the world’s leader in the manufacturing of commercial aircraft, with an overall market share of 53%. The market demand for medium to large size commercial aircraft is expected to increase by 5.2% per year with aggregate sales of $615 billion. The 777 would be the largest and longest haul twin-bodied jet and the most cost efficient plane ever made. In addition the 777 would fill a market niche and a gap in Boeing’s current product line. The aircraft meets customer passenger seat and distance requirements, as it is able to fly up to 14,000 miles and can carry up to 390 passengers. The aircraft’s folding wing tips allows it to fit into smaller slots in airport terminals. Boeing is looking to release the 777 aircraft in May 1995 to United Airlines, who had placed a firm order in 1990.
Boeing is able to leverage some technology from the Defense division’s R&D process and apply it to the commercial aircraft process, which enables them to incorporate fly-by-wire and advanced flying technology. The savings realized in R&D expenditures could therefore be used to develop other aircraft at a reduced cost. Boeing hopes that the new design/production approach would save as much as 20% of the estimated $4 to $5 Million development costs. The aircraft offers high flexibility and cost efficiencies in designing the interior and incorporates the involvement of airlines and engineering to ensure that it meets customer preferences and expectations.
At the end of 1989, Boeing had $97 billion in outstanding back orders on aircrafts. It would take Boeing about 3 years to complete these back orders. Other than the order placed by United Airlines, there have not been any other firm orders to date. Although Boeing would be able to leverage some of the design specs from its other four lines, the total R&D expenses are high and would cost $4 to $5 Billion. There would also be large capital expenditures on manufacturing facilities and training. On average, the project would take 12 to 20 years to break even because there will be negative cash flows before the company would see a profit on this product line. If the product line is not successful, Boeing risks substantially depleting its book value of equity.
The Boeing 777 is in the fastest growing market segment of the commercial airline industry. Overall, airline traffic is expected to increase at annual rate of 5.2% with a 10.6% increase specifically in the Asian market. There is an increasing number of existing aircrafts that will be aging and will present a demand for the replacement of 642 large passenger aircrafts. Boeing has four aircrafts developed with established production facilities. A derivative of these planes and the production facilities can be utilized to reduce design costs and common production facility costs. Overall costs savings can be utilized in the development of the Boeing’s super jumbo jet.
Boeing’s top two customers, Airbus Industrie and McDonnell Douglas, have already announced the production of their own comparable aircraft, targeting the same niche market as the 777. They have a sizable head start on orders and their R&D costs are about 50% less than Boeing’s 777. With lower costs, Airbus Industrie and McDonnell Douglas could drive down the selling price of the 777 from $130 million to $100 million per aircraft. Due to the impact of the war between Iraq and Kuwait and the unstable political and economic climate, oil prices have increased which has resulted in decreased air travel and overall demand. This could have a negative impact on Boeing’s stock price, as the demand for aircraft would decrease as airlines cancel orders. Ultimately, the overall duration of the war and the long range impact on Boeing’s stock price due to the demand for commercial aircraft orders remains unknown.
Estimating opportunity cost of capital for the Boeing 777 project
The opportunity cost of capital can be estimated using the following formula:
4.1. Key Assumptions for the calculation:
The first step in the calculation is to determine the appropriate value for Boeings ß. For our calculation we referred to b’s from Exhibit 9 and selected the value for Boeing calculated in comparison to the S&P 500 Index for the previous 12 months (b = 1.37). The rationale for our selection is that Boeing is listed in the S&P 500 and the index represents a close group of peers for Boeing primarily listing US large cap companies as Boeing. We have chosen the 12 months b considering that a twelve months period is a good reflection of current market conditions. We considered that the longer 58 month range would provide an outdated picture of market conditions while the short term 60 day period would be strongly biased by short term market fluctuations and would be significantly affected by the noise derived from those fluctuations.
Risk free rate:
The risk free rate used was 8.82 percent this rate was chosen because in October 1990, the yield on long-term U.S. Treasury bonds was 8.82 percent and those bonds are considered risk free investments.
Market Risk Premium
Market risk premium used was 5.4% percent as suggested in the case and based on the 64 year geometric average equity-market risk premium.
4.2. WACC calculation:
In order to calculate the b’s of the two main divisions of Boeing, we first need to determine the b for one division. In Exhibit 9, we have been given the b’s for three peer firms that are mainly in the defense industry (Grumman, Northrop and Lockheed). From the information given for the S&P 500 12 month comparative b’s, and given Market-value debt/equity ratios for the firms, we can calculate the unlevered b’s for each company using the following equation:
The Average ß’s for the three “pure play” defense aviation companies is ßAvg = 0.372 (see attachment I).
From there, we can use our newly calculated industry average b for the defense aviation industry to calculate the blevered for Boeing’s defense division using the following equation:
The result for blevered for Boeing’s defense division is 0.376 (see attachment I)
The total firm blevered for Boeing is comprised of a weighted sum of the two blevered of each of its two divisions:
We can calculate b for Boeing’s commercial division by resolving the equation for bcommercial :
From this we can calculate the rate of return on equity for the commercial division, using the following equation:
To estimate rdebt, which is essentially the cost of capital from the debt portion of Boeing’s capital structure, we can use market rates of Boeing’s corporate bonds. Given that Boeing’s long-term debt consist entirely of two bond issues (Exhibit 2), we can calculated a weighted average of the market rate these two issues to arrive at a combined rdebt as follows:
The final step in the calculation is to now plug the values for rdebt, requity and the relative equity and debt proportions:
The final result for the opportunity cost of capital is:
rWACC = 17.89 %
4.2.1. Explanation of Capital–structure weights
To calculate the unlevered bs for Boeing’s the three peer firms operating mainly in the defense industry, which we used as proxies for Boeings defense division, we used their respective capital structures. This provides an insight of what their bs would be if their operations were purely financed through equity.
To calculate Boeings commercial divisions b we now unlever those bs applying Boeings own capital structure, this is because we assume Boeing would finance operations of its commercial division using that proportion of debt and equity.
4.2.2. Explanation of WACC:
WACC reflects the relative weighted costs of different sources of capital. From the given capital-structure weights, the rates for debt and equity calculated above, and the given marginal tax rate, we can now calculate Boeing’s Weighted Average Cost of Capital for Commercial Division:
4.3 Potential long-term & short-term impacts of economic climate and impending war
Given the context that the launch of the Boeing 777 is coming on the eve of war, conceivably the assumptions shown above in the calculation of the total B for the firm may change. As shown above, total b for the firm is given as a weighted sum of the B’s for each division (commercial and defense). If the demand for defense products increases with the war, perhaps the relative weighting of the defense division’s b should likewise increase. The percent weighting used above was taken from given information of the relative percent of revenues generated by each division. As the relative percent of revenue changes in each division, likewise the weighting of the division’s bs will also change.
As explained in the given case information, regarding Boeing’s commercial aircraft division, growth in demand in the commercial airline industry is a function of increases in passenger air traffic, which itself is a function of overall economic growth. The two form a direct relationship, such that as the economy grows, so does passenger air traffic, and therefore demand for commercial aircraft also grows. Any decline or stagnation in economic growth results in a corresponding decline or stagnation in passenger air traffic, and therefore demand for commercial aircraft. Regarding Boeing’s defense division, increased demand for defense aircraft leads to growth in the defense division. Although speculative in nature, it is probable from past precedent that the impending war will cause growth in both of Boeing’s major divisions (commercial and defense). Regarding commercial, war often leads to a general period of economic growth. Increased government spending is a large driver of this temporary growth, and specifically relevant to Boeing is increased government spending for defense aircraft. Therefore, revenues in Boeing’s defense division will likely increase leading to growth. The general period of economic growth precipitated by war will likely cause an increase in passenger air travel, given the direct relationship already discussed herein. Therefore, the likely impact of war will be growth in the commercial division, as well. Both of these scenarios show the potential impact of war and general economic prognosis on demand in the commercial and defense divisions.
However, short-term impacts will be potentially quite opposite. As per the case, the recent events in Kuwait had led to an increase in fuel prices. This conceivable could cause increased expenses for airline service providers, and may translate into direct price increases. These increased expenses and corresponding price increases to consumers will likely lead to a temporary dip in passenger air traffic, and therefore a corresponding contraction of demand for products in Boeing’s commercial division. However, as the Boeing 777 launch is slated as a 35 year project, the long-term impacts of general economic growth and the impact of this impending war are likely more relevant than the short-term impact of escalated fuel costs.
Assessment of the Boeing 777 project based on the estimated WAAC
5.1 Revenue/cost scenarios & the project profitability – Sensitivity analysis
In order to assess the potential impact relevant scenarios to be considered are those that impact the project overall cash in- and out-flows by either impacting the project revenue (Sales volumes or price) or by impacting the project expenditures (e.g. R&D and SG&A expenses).
Base Scenario (Boeings assumptions)
Given the information in the case, we can see that Boeing’s analysts are currently projecting a project IRR of 18.9% (Exhibit 7, p. 203). This IRR value aligns with their assumed 1000 Unit sales volume, and $130M Unit Price. From the information given in Exhibit 6, Boeing has a historical ratio of GS&A expense-to-sales ratio of about 4% (historical range 2-5%). Given also in Exhibit 6 is an estimated 3% ratio of R&D expense-to-sales. Using these ratios, the IRR is 18.9% as seen in Exhibit 7’s Sensitivity Analysis table. Given the project’s WACC calculated above as 17.89%, IRR > WACC in the expected case. Therefore if Boeings sales and cost assumptions are accurate the project is economically attractive.
We can see that these 4 variables, Sales Volume, Sales Price, R&D expense-to-sales ratio, and GS&A expense-to-sales ratios all impact the forecasting model for the project returns.
To examine the potential downside/upside ranges for variations in these assumptions, we can use Exhibit 7 to find the IRRs for the extreme hi-/lo-values to get a sense of the modeling sensitivity to fluctuations in different assumptions.
First, regarding Revenue Assumptions of Sales Price and Sales Volume, we can calculate the range of IRR’s resulting from fluctuation in this metric (Table 5.1).
Table 5.1 – Sensitivity Analysis: Revenue Assumptions
|Extreme Low||Expected||Extreme High|
Regarding Expenditure Assumptions of % R&D Expense/Sales and %GS&A/Sales, we can calculate the range of potential impact on IRR in the Sensitivity Analysis shown in table 5.2.
Table 5.2 – Sensitivity Analysis: Expenditure Assumptions
|Extreme Low||Expected||Extreme High|
Given the exposition of hi-/lo- scenarios above, we can see that the model is sensitive to fluctuations in the assumptions used. Analyzing these Key Assumptions in consideration of external Real World Forces shows us that there are a few scenarios of special significance to potential outcomes.
One pessimistic scenario calculated assumes that, due to competition from Airbus and McDonnell/Douglas in the mid-to-large passenger aircraft segment, pricing for Boeing’s 777 may be forced downward to $100M from the baseline assumption of $130M. From a modeling of this scenario, for a given $100M Sales price and using Boeing’s current baseline assumption of 1000 sales units, we arrive at an IRR of 16.1% Under this scenario, and considering our estimated WACC the project would not be economically attractive. Clearly the impact of competition on price will affect IRR and the overall project profitability.
In another significant scenario, analyst estimation of economic decline may force unit sales downward to 700 versus the baseline assumption of 1000. From modeling this scenario with 700 assumed sales units and the baseline assumption of $130M sales price, we arrive at an IRR of 16.3%. Again also under this scenario, and considering our estimated WACC the project would not be economically attractive
Another factor that could impact scenarios is Boeing’s assertion that it can reduce total R&D Investment by 20% by use of the “current engineering” approach (p.203). Boeing expects to leverage its knowledge and expertise in the defense division to reduce ongoing R&D Expenditures. The calculations both for baseline as well as hi- lo- cases in the sensitivity analysis above do not reflect this projected reduction. Therefore, should Boeing actually realize a reduction in R&D expense, the resulting net cash flows would increase, and IRR would also increase above all values shown above. To illustrate this potential optimistic scenario, we must first quantify this projected reduced R&D expense. R&D Expense is expressed as a percentage of sales per Exhibit 7. Therefore, we can quantify the 20% reduction in ongoing R&D expense as follows:
20% Reduction = 3% R&D Expense/Sales at Baseline – 20%*(3% R&D Expense/Sales)
= 2.6% R&D Expense/Sales
From Exhibit 7, we can see that the assumptions for %R&D Expense/Sales and for %GS&A/Sales are show in 1% increments. At the baseline assumption of %GS&A = 4%, we can see that for every 1% increase in % R&D Expense/Sales, IRR increases by approximately 1%. Therefore we can infer that at 2.6% R&D Expense/Sales, IRR will be approximately 19.5%
5.2. Limitations of discounted cash flow analysis
Discounted cash flow analysis has limitations. Modeling of cash flow is a static model. It assumes you will proceed with the very assumptions used on day 1 for the entire projected length of the project. In reality, this is hardly ever the case. Often, you will reassess and potentially vary your investments and expenditures over the course of the project. Likewise, DCF ignores several factors that resist financial modeling, for example external threats and the competitive landscape, the relationship or interaction between one part of the business and another, and sometimes the impact of organizational learning and a reduction in expenses that comes from improvements in efficiency over time. Specifically in this case, the cash flow analysis assumptions were calculated and utilized above ignoring Boeing’s assertion that it will reduce total R&D expense by 20% over the project, and it also ignored sunk costs, which were R&D expenditures prior to October 1990.
Recommendation for Boeings CEO Frank Shontz
Innovation and investment in innovation are the keys to success for any corporation. Therefore we suggest that Boeing’s CEO Frank Shontz should continue to innovate and invest in new projects to remain competitive and successful. Boeing’s current fleet of aircrafts is ageing and Boeing needs to update its fleet to compete successfully with Airbus.
Finally, Shontz also needs to decide which investment is correct for its strategic goals. The data and calculations done above suggest that the 777 project is a perfect opportunity for Boeing to update in ageing fleet and take advantage of prevailing market conditions. The Boeing 777 also fits a gap in terms of range and passenger capacity which Boeing is currently lacking.
The IRR’s for the Boeing 777 project range from 13.6% in a pessimistic case to a potential upside of 23.6%. Given that the discount rate ranges from 10% to 20%, we can see that the project performance IRR exceeds the baseline discount rates (representing the market return rate). Therefore, quantitatively, the data supports the strategic advantages outlined above for the investment in the Boeing 777 launch.
Attachment I – Cost of capital calculations
|% Revenues from Defense||0.87||0.89||0.85|
|S&P 500 12 month b Levered||0.73||0.72||0.69|
|1+ (1-T)* D/E||2.15896||1.85008||1.78012|
|b Unlevered Defense division||0.338||0.389||0.388|
|Average b for Defense for all 3 Defense Companies||0.372|
|Boeing Market-Value D/E||0.018|
|b Levered Defense for Boeing||0.376|
|b Total Boeing=||(% defense * b Defense ) + (% Commercial * b Commercial)|
|Therefore B Commercial =||(b Total – (% Defense * b Defense))/(% commercial)|
|r equity =||Risk free rate + (Market Rate – Risk Free Rate)*B commercial||Market Rate – Risk Free rate = Market Premium = 5.4% as given in case|
|r equity =||0.0882 + 0.054*1.719 =||0.18103814|
|Rdebt is the weighted average of the interest rates of 2 outstanding bonds issues in exhibit 2|
|Market Value of Equity||14896.76||(given in footnotes of Exhibit 2)|
|Market Value of Debt||271.5||(given in footnotes of Exhibit 2)|
|Total Value of Firm||15168.26|
|r (wacc) =||0.17894|
Attachment 2: Pessimistic Revenue Assumptions
Attachment 3: Optimistic Expenditure Assumptions