Case study The Boeing 7E7

Financial Forecast and Analysis

Exhibit 8 contains a 20-year forecast of free cash flows from the Boeing 7E7 project consistent with public information released by Boeing, Airbus, analysts, and other experts in the field. See the Appendix for detailed forecast assumptions. The primary implication of the forecast is that the 7E7 project would provide an internal rate of return (IRR) close to 16%. This assumes that Boeing would not only deliver the promised plane specifications, but that Airbus would be unable to replicate the 7E7 efficiencies.

Based on both analysts' and Boeing's expectations, the base case assumes that Boeing could sell 2500 units in the first 20 years of delivery. Pricing was estimated using 2002 prices for Boeing's 777 and 767. The 7E7 would be a hybrid of the two planes in terms of the number of passengers and range. By interpolating between the 777 and 767 prices, it was possible to estimate the value placed on the range and number of passengers. Using this methodology, without any premium for the promised lower operating costs, the minimum price for the 7E7 and 7E7 Stretch was estimated to be $114.5 million and $144.5 million, respectively, in 2002. The forecast assumed that customers would be willing to pay a 5% price premium for the lower operating costs.

The IRR, which is consistent with "base case" assumptions, was 15.7%. But, the estimate of IRR was sensitive to variations in different assumptions. In particular, some obvious uncertainties would be the number of units that Boeing would be able to sell and at what price. For example, if Boeing only sold 1,500 units in the first 20 years, then, as shown in Exhibit 9, the IRR would drop to 11 %. This might occur if air travel demand worsened, or if Airbus entered this segment with a new competing product.

Additional unknown variables were the development costs and the per-copy costs to build the 7E7. Boeing's board was anxious to minimize those costs. The forecast assumes $8 billion for development costs; however, analyst estimates were in the $6 billion to $10 billion range. The cost to manufacture the 7E7 was also subject to great uncertainty. On the one hand, engineers were challenged to build a mid-size air- craft with long-range capabilities. The engineering design to achieve this could push building costs up significantly. Conversely, if Boeing succeeded in using composite materials, which required a fraction of the normal assembly time, then construction costs would be lower. Consistent with Boeing's history, the base case assumes 80% as the percentage of cost of goods sold to sales. As shown in Exhibit 9, however, the IRR of the 7E7 was very sensitive to keeping production costs low.

Cost of Capital

Boeing's weighted-average cost of capital (WACC) could be estimated using the following well-known formula:

WACC = W_dr_d(1-t) + W_er_e

Where:

8 "An Ongoing Rivalry"

W_d = Proportion of debt in a market - value capital structure r_d = Pre-tax cost of debt capital t = Marginal effective corporate tax rate

W_e = Proportion of equity in a market - value capital structure r_e = Cost of equity capital

Exhibit 10 gives information about betas and debt/equity ratios for Boeing and comparable companies. Exhibit 11 provides data about Boeing's outstanding debt issues. While Boeing's marginal effective tax rate had been smaller in the past, it currently was expected to be 35%. In June 2003, the yield on the three-month U.S. Treasury bill was 0.85%, and the yield on the 30-year Treasury bond was 4.56%. On June 16, 2003, Boeing's stock price closed at $36.41.

Analysts pointed out that Boeing actually consisted of two separate businesses: the relatively more stable defence business and the conversely more volatile commercial business. Defence corporations were the beneficiaries when the world became unstable due to the terrorist attacks on September 11, 2001. Furthermore, the United States, along with some of its allies, went to war against Iraq on March 20, 2003. While Bush declared an end to major Iraqi combat operations on May 1, 2003, as of June 16, the death toll in Iraq continued to rise on a daily basis. A different type of risk emanated with the outbreak of SARS. On February 1, 2003, China announced the discovery of the deadly and contagious illness that subsequently spread to Canada and Australia. As of June 16, travel warnings were still outstanding. Thus, the question arose of whether one should estimate Boeing's cost of capital to serve as a benchmark- required rate of return. Would a required return on a portfolio of those two businesses be appropriate for evaluating the 7E7 project? If necessary, how might it be possible to isolate a required return for commercial aircraft?

Conclusion

Within the aircraft-manufacturing industry, the magnitude of risk posed by the launching of a major new aircraft was accepted as a matter of course. With huge, upfront, capital costs in an environment of intense technology and price competition, there was no guarantee of success or major significant losses if the gamble did not payoff. At a time of great political and economic uncertainty, Michael Bair said:

Clearly, we have to make a compelling business proposition. It could be [that] we'll still be in a terrible business climate in 2004. But you can't let what's happening today cause you to make bad decisions for this very long business cycle. This plane is very important to our future.⁹

Central to any recommendation that Bair would make to Boeing's board of directors was an assessment of the economic profitability of the 77 project. Would the project compensate the shareholders of Boeing for the risks and use of their capital? Were there other considerations that might mitigate the economic analysis? For instance, to what extent might organizational and strategic considerations influence the board? If Boeing did not undertake the 7E7, would it be conceding leadership of the commercial-aircraft business to Airbus?

Revenue Estimation

In order to project revenues for the project, several assumptions were made about the expected demand and timing for the units, their price, and price increases.

Demand: Boeing estimated that in the first 20 years they would sell 2,000-3,000 units.¹⁰1 Frost & Sullivan, aviation industry analysts, predicted at least 2,000 units.¹¹ Analysis assumes 2,500 units in years 1 through 20. Years 20-30 assume unit sales equal to year 20. First delivery of 7E7 expected in 2008 and 7E7 Stretch in 2010.

Timing of demand: Units sold per year is the percentage of the total units in the first 20 years as shown in Exhibit 6 which uses an historical average of the 757 and 767 unit sales during their first 20 years. The Boeing 7E7 is expected to be a replacement aircraft for the 757 and 767. Analysis assumes the 7E7 Stretch accounts for only 20% of unit sales in its first year of delivery and 50% thereafter. If the total number of unit sales per year is an odd number, the 7E7 units are rounded up and the 7E7 Stretch are rounded down.

Price: The expected price of the 7E7 and Stretch version is a function of the 767 and 777 prices in 2002. Using range and capacity as the primary variables, the 7E7 and 7E7 Stretch would be expected to have a minimum price of $114.5 million and $144.5 million respectively in 2002 dollars. This does not include a premium for the expected lower operating costs and flexibility of the 7E7. The analysis assumes a 5% price premium as a benchmark resulting in expected prices of $120.2 million and $151.7 million in 2002.

Rate of price increases: Aircraft prices are assumed to increase at the rate of inflation. Inflation is assumed to be 2% per year until 2037.

Expense Estimation

Costs of goods sold: The average cost of goods sold for Boeing's commercial-aircraft division was 80% over the three-year period 2000-2002. The range was 77.9% to 81.1%. The analysis assumes 80% as the COGS.

General, selling, and administrative expense: The average general, selling, and administrative expense for Boeing was 7.5% over the three-year period 2000-2002. The range was 7.4% to 7.7%. The analysis assumes 7.5% as the general, selling, and administrative expense.

Depreciation: Boeing depreciated its assets on an accelerated basis. The forecast uses 150% declining balance depreciation with a 20-year asset life and zero salvage value as the base.

Research and development as a percentage of sales: The average research and development expense for Boeings commercial-aircraft division as a percentage of commercial-aircraft sales was 2.3% over the three-year period 2000-2002. The range was 1.8% to 2.7%. During that period, Boeing did not have any extraordinary new commercial aircraft development expenses. The analysis, therefore, assumes 2.3% as the estimated research and development expense. That does not include the initial research and development costs required to design and develop the 7E7.

Tax Expense: Boeing's expected marginal effective tax rate was 35%.

Other Adjustments to Cash Flow

Capital expenditures: The 1998-2002 average for capital expenditures as a percentage of sales was 0.93. During this period, Boeing did not have any extraordinary new commercial-aircraft development expenses. At the time Boeing had six families of aircraft: the 717,737,747,757,767, and 777. The average capital expenditures per family line, as a percentage of sales, was therefore 0.16%. This does not include the initial capital expenditure costs required to develop and build the 7E7.

Changes in working capital requirements (WGR): For the years 2000-2002, Boeing had negative working capital due to factors such as advance customer payments. The analysis assumes that the commercial segment of Boeing would require positive working capital. The years prior to 2000, Boeing had positive working capital. The 1997-1999, three-year average of working capital as a percentage of sales is 6.7% with a range from 3.5% to 11.2%. The analysis assumes this percentage.

Initial development costs: Development costs include the research and capital requirements needed to Design and build the 7E7. Analysts estimated between $6 billion and $10 billion.¹² The analysis assumes $8 billion. Assuming a launch in 2004, analysts expected spending to peak in 2006. Timing of the development costs are assumed to be 2004: 5%, 2005: 15%, 2006: 50%, 2007: 15%, 2008: 10%, and 2009: 5%. It is estimated that 75% if the initial development costs are research and development expenses, while the remaining 25% are capital expenditures.

1. Discuss and calculate the appropriate required rate of return against which to evaluate the prospective IRRs from the Boeing 7E7?
2. Critically discuss why the capital asset pricing model is not used to estimate the firms cost of capital directly?
3. Use the capital asset pricing model to estimate the cost of equity. Which beta did you use? Critically discuss the reasons of your choices?
4. When you used the capital asset pricing model, which risk-premium and risk-free rate did you use? Critically discuss the reasons of your choices?
5. Estimate the Boeings Cost of Debt? Critically examine if the Boeings debt was also subject to commercial and defence risk, and how did you separate out the commercial risk component?
6. Critically discuss why the CAPM to not used to estimate the cost of debt?
7. Discuss the rationale behind using the weighted average of all debt or a weighted average of long-term debt with maturities that match the length of the project?
8. Why book values of the capital-structure weights are not used in calculating the weighted average cost of capital?

9. Judged against your calculation of the required rate of return above, how attractive the Boeing 7E7 project was?