BOEING 7E7

Case Analysis Report

Introduction
Boeing is an American multinational corporation that manufactures and provides
commercial jetliners, military aircrafts, satellites, weapons, communication system and other
military platforms and defense systems. It is also the one of the largest defense contractor in
the world. Boeing focused on the research and development to provide excellent and unique
specification of aircraft that no one can replicate.

In 1994, Boeing 777 had been highly successfulin the commercial aircraft industry. After
few years, it cancelled its two programs. One is the Sonic Cruiser which promised to fly 15%
to 20% faster than any other commercial aircraft. It was cancelled due to insufficient market
interest. The passengers were not willing to pay premium price for a faster ride. In 2003, airline
profits had declined due to war of US and Iraq, global terrorism and the spread of deadly
disease called SARS. In the same year, Boeing 7E7 was announced by Michael Blair, the leader
of the 7E7 project. This aircraft has the capacity of 200 to 250 passengers that could travel both
short domestic and long international flights. It would use less fuel, incur cheaper operating
costs and has long or short distance flexibility that would attract customers at the right price. It
would be the first commercial aircraft built primarily with carbon-reinforced material which was
stronger and lighter than traditional aluminum. It was also said that it would use composites to
reduce manufacturing costs. However, it has risk. Composite materials were suspected as
contributory cause to a 2001 plane crash in New York. 7E7 were subsequently called
Dreamliner. For Airbus, its chief rivalry, it was called as salespersons dream and engineers
nightmare. And since it has the capability for long distance flights, it would need a Snap-on
wing extension. However, it was very costly. The cost of the project could be high as $10 billion
and there was an imminent veto threat if the cost did not shrink by billions.

Boeing and Airbus dominated the large plane (100+ seats) commercial aircraft industry.
Historically, Boeing lead in the said industry while for a number of measures, Airbus became
the number one. Airbus was its main competitor. It already recorded more plane orders than
Boeing. In 2006, A380, a superjumbo four-engine jet, had been scheduled to fly with a 550-
passenger configuration and long distance range up to 8000 miles. It would be the largest
passenger aircraft ever built!

The Boeing Company has two primary segments namely commercial airplanes and
integrated defense system. The major rivalry in the defense system was Lockheed Martin.
Nevertheless, Boeing was awarded $16.6 billion defense contract last 2002. The companys
defense revenues were rising while commercial aircraft revenues were declining. For
commercial aircraft segment, there were two kinds of models designed to meet the needs of
every customers. These are the standard and wide-body models. On the other hand, the
demand for commercial aircraft was influenced by business cycles, consumer confidence and
exogenous events n short term. For long term, the GDP, international trade, low fares become

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paramount. Eventually, the company had been considering the two members of 7E7 family,
base and stretch version. These two have different specifications. The Stretch version is much
larger than baseline version and it has longer distance to travel. Before the plan can be started,
Blair should need to complete a valuation of the project and prove to the board if the 7E7
project would be profitable for the companys shareholder.

Statement of the Problem

Michael Bair, the leader of the 7E7 project, introduced the new aircraft to the board. And
presenting this new project to the board required him to create a financial analysis regarding
this project.
The following are the main problems found in the case:
1. How would Bair estimate the weighted-average cost of capital?
2. Should the board approve the 7E7?

Porters Five Forces Model

Rivalry Among
Competitors LEGEND
4 0 No threat to the business
1 Insignificant threat to the business
3 2 Low threat to the business
Threat of New 2 Threat of 3 Moderate threat to the business
4 Significant threat to the business
Entrants 1 Substitutes 5 High threat to the business
0

Bargaining Bargaining
Power of Power of
Suppliers Buyers
Threat to New Entrants | LOW
Because of the presence of mainly two large companies in the industry, the threat to
new entrants in very low. Competition between Boeing and Airbus has been considered as a
duopoly. This resulted from a series of mergers within the global aerospace industry, with
Airbus beginning as a European consortium while the American Boeing absorbed its former
arch-rival, McDonnell Douglas in a 1997 merger. Other manufacturers, such as Lockheed Martin
and Convair in the United States and British Aerospace, Dornier and Fokker in Europe, were no
longer in a position to compete effectively and withdrew from this market. The industry also
requires high research and development costs and production costs. It can be concluded that
the new competitor that is planning to enter the market will eventually lost because the market
has been penetrated already by the two giant companies.

Bargaining Power of Suppliers | LOW

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 With a high number of available suppliers worldwide, the aircraft industrys bargaining
power of suppliers is relatively low. Since there are only two basic companies in the industry,
the suppliers consider them as their primary consumers.

Bargaining Power of Buyers | MODERATE

Anecdotal evidence on the widespread use of price discounts and favorable financing
options suggests that aircraft companies compete in prices. As an example, a Harvard Business
School case study reports significant underbidding between Boeing and Airbus, and cites the
former Airbus Chairman Alan Boyd admitting to pricing for market share...we had to do it in
order to get our feet in the door. Yet price competition might be a questionable assumption
during the periods when firms face capacity constraints. Tyson (1992) reports that the industry
sources claim that capacity constraints were not binding during the 1980s.

Threat of Substitute Products | LOW

There is no considered substitute product for aircrafts. If it will be compared to a ferry,
both have different functions and uses. Aircrafts are being used for air navigation while ferries
are for sea travelling. Airline companies would not have any choice but to get their aircrafts
from either Boeing or Airbus.

Rivalry among Competitors | SIGNIFICANT

There are two basic key players in the aircraft industry. The industry possesses greater
competition because industry players are equal in size and power, and therefore compete for
market dominance. The industry also requires higher fixed costs and will require firms to
compete to be able to gain the largest amount of market share possible to cover the fixed
costs. The industry has already slowed down in terms of growth and has already reached the
maturity stage of the industry life cycle; therefore, increasing the competition for higher market
share and increasing profit growth. The two players also compete in terms of pricing. During
2001, Airbus having an approximately 55% market share has surpassed Boeing, with 45%
because of re-organization. Due to the presence of primarily two large companies in the
industry, the rivalry among competitors is significant.
SWOT Analysis

Strenghts
It has dominated the large plane (100+ seats) commercial-aircraft industry.
It focuses on the R&D for aircrafts and the defense system.
It occupies a large market share.
It is competent in terms of excellence and efficiency of the products.
It produced aircrafts designed to meet the needs of the short to long range markets.
It has several business segments such as commercial aircrafts and defense system.
7E7 projects will use less fuel, incur lower operating costs and has long and short
distance flexibility.
7E7 would be the first commercial aircraft built primarily with carbon-reinforced
material which was stronger and lighter than traditional aluminum.

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 7E7 provides flight entertainment, internet access, health monitoring and so on.
Defense revenues are rising.
The use of composites would reduce manufacturing costs.

Weaknesses
It requires large initial cash outflow
It cannot easily charge customers for premium prices so the two programs including
Sonic Cruiser were cancelled.
Airbus, its main competitor, recorded more orders and lead the commercial aircraft
market.
The demand is subject to short-term, cyclical deviations.
It was not able to deliver 1083 commercial aircraft and had declining backlog of about
$68 billion.
The board wanted to keep 7E7 development costs down to only 40% of what I took to
develop 777.
The GDP will grow for the next 20 years.

Opportunities
It could offer more routes at cheaper prices.
It could produce more types of aircrafts that has unique specifications to remain
competitive.
It could focus on its other business segments when the demand for commercial aircrafts
is weak.
It should have continuous R&D and innovations.
Based on estimation, there will have more than 400 city pairs for nonstop flight of 7E7.

Threats
There is an imminent veto threat if the development costs of $10 billion did not shrink
by billion.
There is a risk on the composite materials.
There is a close competition with Airbus for commercial aircraft and Lockheed Martin in
defense contracts.
External events such as US-Iraq war, global terrorism and SARS may affect the
operations as well as revenues.
There is a risk that Airbus may replicate the unique specifications of aircrafts.
There is a threat on its revenues due to events in September 11 and bursting of
technology bubble.

Alternatve Courses of Action

7E7 or Dreamliner is a promising project with a concept that is customer-driven. With
a higher performance and fuel efficiency, the new aircraft is very commendable. Also, this will
position Boeing in the market and may possibly regain the taken market share by Airbus.

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 And just like in releasing any new product line, a proper timing should be guaranteed to
ensure success. However, in this case, external and uncontrollable factors are making things
worse for 7E7 such as the fear for global terrorism, SARS, and the weak financial condition of
airlines.
To help the board in deciding whether to accept or reject the project, the weighted-
average cost of capital is computed that will be compared to the IRR.

Calculating the WACC

Determining the Cost of Equity
To compute for the WACC, the cost of equity component is first estimated using Capital
Asset Pricing Model (CAPM). However, estimating the beta is the first concern in this case. Since
there are two segments for Boeing (commercial aircraft and defense), it is deemed appropriate
to use different betas for these two segments as inputs to the CAPM. An explanation for this is
that the segments bear different risks and using one beta to represent the other is faulty and
can result to improper estimation.

Another concern for this case is the proxy of the market portfolio and the fitting time
interval. Between the two indices (S&P 500 and New York Stock Exchange), the NYSE has a
higher value index. And ideally, this is a better measure. Addition to this, Boeing is listed on
NYSE; therefore, the estimation of beta is based on this index. As for the time interval selection,
60-day period is used since this already includes the Iraq war and the peak of the SARS illness.
The 60-day beta of 1.62 is more appropriate than the other two because it reflects the current
market condition; meanwhile the 21-month beta will mirror the 9/11 event which has hugely
affected the stock and the 60-month data is already too long to be used as a basis.

There are series of betas mentioned in the case; and to get the defense beta, similar
firms such as Lockhead Martin and Northrop Grunman data are used. The average unlevered
betas of these two firms are used as the asset beta of the defense segment.

Then, to determine the beta of commercial aircraft segment, the weights of commercial
airplanes and integrated defense system are obtained by using the revenue as a basis of
computation. The beta of the commercial segment is computed following this formula:
[() ( )( )]
() =
()

Using the formula above, the computed unlevered commercial aircraft beta is 2.03.
Using the Hamada equation, this beta is levered which is 2.72.

Based on the yield for a 30-year U.S. treasury bond of 4.56% as risk-free rate, 74-year
market risk premium in geometric mean of 4.70%, and the levered commercial aircraft beta of
2.72, the cost of equity amounting to 17.34% can be computed (see table 3).

Determining the Cost of Debt

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 Getting the weighted average of all available debt information is made to estimate the
cost of debt. In this case, individual yield-to-maturity (YTM) rate of all the outstanding bonds of
the Boeing Company as of June 2003 are proportioned to its market value over the total market
value to get the weighted yield-to-maturity. These weighted yield-to-maturity rates are then
totaled which is used as the cost of debt.

As for the tax rate, theoretically, the expected marginal tax rate is utilized instead of the
historical, average tax rate. Thus, it is more appropriate to use the marginal effective tax rate of
35% as the case notes.

Determining the Debt and Equity Weights

Market values are used in determining the capital structure weights. In this case, the
market value of debt and equity ratio is already given 0.525. From this, the market values of
debt and equity can be algebraically derived, having 34.4% and 65.6% respectively.

Estimating the WACC

Using all the inputs mentioned above, the WACC will result to 12.56%.
Recommendation

Based on the data computed, it can be recommended that the board should approve
such project. As a general rule for Internal Rate of Return (IRR), the company should accept a
project if the IRR is greater than the Weighted Average Cost of Capital (WACC). The WACC can
be a measure of required rate of return and discount rate for new investment evaluation. If the
IRR is greater, it means thatsuch investment project is earning more than what is required by
the company.

However, it is inevitable for the company not to take any risks because unexpected ones
may just suddenly appear and affect all significant decisions in the company. In relation to sales
price and volume, if both of them are substantially low like only 1500 units were sold at 0%
price premium, IRR will now be less than the WACC which may lead to rejection of Boeing 7E7.
Also when Cost of Goods Sold and development costs will be significantly high, same negative
decision may also arise. Operational inefficiencies may arise, which can increase costs and
affect profit.

In order to prevent such things from happening, the board should improve their risk
management by first establishing milestones regarding the investment project. They should
monitor its development and progress, and quickly change anything that is causing problems.

But through the given data in the case exhibits and estimates by the analysts, financial
calculations in this paper heavily states that there is a good probability that the project will be a
success and will increase the value of the company and wealth of stockholders. Being a
company committed to be engaged in the commercial airplane industry, it is of no doubt that
the board will be urged not to think twice in approving Boeing 7E7. Huge potential benefits can

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be gained if the project will be successful. So in approving the project, the board should also
take into consideration how to act carefully and properly so that the company would not suffer
any losses due to weak risk management being conducted.

Appendix

Table 1 Unlevered Betas

Lockhead Martin Northrup Gorman Boeing
Tax Rate 35% 35% 35%
Market Value Debt/Equity Ratio 0.41 0.64 0.525
60-Day Equity Beta based on NYSE 0.37 0.3 1.62
Beta (unlevered) 0.29 0.21 1.21

Table 2 Weights of Segments

Revenues

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Commercial Airplanes $ 28,387
Integrated Defense Systems 24,957
Others 725
Total $ 54,069
Commercial Airplanes 54%
Integrated Defense System 46%

Table 3 Cost of Equity

Levered, Commercial 2.72
30-Year Treasury Bond (Rfr) 4.56%
74-Year Equity MRP (Geometric Mean) 4.70%
Cost of Equity 17.71%

Table 4 Cost of Debt

Debt Amount ($) Price ($) Market Value ($) YTM Weighted YTM
202 106.175 214.474 3.911% 0.167%
298 105.593 314.667 3.393% 0.218%
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 5,022.12 5.340%
Table 5 WACC
Weight for Debt 34.43%
Weight for Equity 65.57%
Cost of Debt 5.340%
Cost of Equity 17.34%
WACC 12.56%

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