I have Attached the Boeing 7e7 Case that I need help with. I copy and pasted the Questions Below.

Part 1: Case Report Summary

A. Summary

Part 2: Case Report Questions

B. Why is Boeing contemplating the launch of the 7E7 project? Is this a good time to do so?

C. How would we know if the 7E7 project will create value? What values should be compared?

D. The weighted-average cost of capital is a simple formula but people can disagree about the

estimates. How can there be such a range of cost of capital estimates?

E. Should Boeing?s Board approve the 7E7? Why or why not?

UVA-F-1449-SSRN Version 4.3 THE BOEING 7E7 We still have a lot to get done as we move toward authority to offer the 7E7 to our customers. The team is making great progress -understanding what our customer wants, developing an airplane that meets their needs, and defining a case that will demonstrate the value of the program. Michael Bair, Boeing Senior Vice President.1 In early 2003, Boeing announced plans to design and sell a new \"super-efficient\" jet dubbed the 7E7 and subsequently called the \"Dreamliner.\" But news over the next six months depressed a market for aircraft that was already in sharp contraction: the U.S. had gone to war against Iraq, spasms of global terrorism offered shocking headlines, and a deadly illness called SARS had resulted in global travel warningsfor these and other reasons, airline profitability was the worst seen in a generation. This seemed like an incredible environment in which to launch a major new airframe project. But on June 16, 2003, Michael Bair the leader of the 7E7 project, announced at the prestigious Paris Air Show that Boeing was making \"excellent progress on the development of the 7E7 and continues to be on track to seek authority to offer the airplane.\"2 Bair aimed to seek from Boeing's Board of Directors early in 2004 a firm commitment to proceed with the project. If the Board approved the plan, he could start collecting orders from airlines and expect passengers to start flying the new jets in 2008. Between now and his recommendation to the Board he would need to complete a valuation of the 7E7 project and gain the support of Boeing's CEO, Philip Condit and other senior managers. Would the financial analysis show that this project would be profitable for Boeing's shareholders? Origins of the 7E7 Project Boeing had not introduced a new commercial aircraft since it rolled out the highly successful 777 in 1994. Later in the 1990s, however, Boeing announced and then cancelled two 1 2 \"Bair Provides Update on Boeing 7E7 Dreamliner.\" Le Bourget, June 16, 2003. Ibid. This case was prepared by Professors James Tompkins and Robert Bruner from public information as a basis for classroom discussion. Copyright 2004 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School Foundation. -2- UVA-F-1449 new commercial aircraft programs. The most prominent of these was the \"Sonic Cruiser\" which promised to fly 15 to 20 percent faster than any commercial aircraft and bragged a sleek and futuristic design. Unfortunately for Boeing, after two years of developing the Sonic Cruiser, their potential customers were sending a message that passengers were not willing to pay a premium price for a faster ride. Boeing was now long overdue to develop a product that would pull it out of a financial slump and help it regain some of the commercial aircraft business it had lost over the years to Airbus, its chief rival. With the 7E7, an Airbus executive argued that Boeing seemed to be promising a \"salesperson's dream and engineer's nightmare.\"3 The 7E7 would carry between 200 and 250 passengers, be capable of both short domestic flights as well as long international hauls, use 20 percent less fuel than existing planes of its projected size and be 10 percent cheaper to operate than Airbus's A330-200. At a time when major airlines were struggling to turn a profit, less fuel, cheaper operating costs, and long or short distance flexibility would be a very attractive package at the right price. Skeptics of the 7E7 were not in short supply and suggested that the name \"Dreamliner\" was appropriate. To make the plane more fuel efficient, the 7E7 would be the first commercial aircraft built substantially with carbon-reinforced material that was both stronger and lighter than aluminum. In addition, Boeing was promising greater fuel efficiency by using a more efficient engine. Boeing claimed that the use of composites would also reduce its manufacturing costs. The goal would be to design a plane with fewer components that could be assembled in three days as opposed to the existing 20 days it takes to rivet together the Boeing 767. The use of composite materials however had its risks. First, composite materials were suspected as a contributory cause to a plane crash in New York in 2001 and would therefore have to overcome regulatory scrutiny. Second, Boeing would have to radically change its production methods. The last time Boeing had made a major production change was in 1997 in an effort to cut costs. However, the process was not smooth, resulting in two production lines being shut down for 30 days and hundreds of missed airline deliveries. The ability to produce a short and long distance aircraft would also have to overcome engineering obstructions. Analysts argued that building a plane that would do short hops in Asia and long Trans-Atlantic flights would require two versions of the plane with different wingspans.4 Boeing engineers were considering the possibility of snap-on wing extensions. The question was whether this would be too costly and technically feasible. Finally, there was the matter of Boeing's board. Two of the most powerful members of the 11-person Board, Harry Stonecipher and John McDonnell, were rumored to have raised serious cost concerns regarding the 7E7. While the cost of developing the 7E7 project could be as high as $10 billion, a veto threat could be imminent if that number did not shrink by billions. More specifically the Board wanted to keep 7E7 development costs down to only 40 percent of 3 4 \"Will Boeing's New Idea Really Fly?\" Business Week, June 23, 2003. Noted by Richard Aboulafia, a senior analyst at Teal Group consultant, ibid. -3- UVA-F-1449 what it took to develop the 777. Pressure from the Board was also to keep the 7E7 per-copy costs to only 60 percent of the 777 costs. In response, Philip Condit, Boeing's CEO and Chairman, was quoted as saying that \"Boeing has a responsibility to develop jetliners for less.\"5 He knew however that if Boeing did not take bold risks in the commercial aircraft industry that their days as a serious competitor to Airbus could be numbered. Commercial Aircraft Industry In 2002, two companies dominated the large plane (100+ seats) commercial aircraft industry: Boeing and Airbus. While Boeing had historically held the lead in this market, by a number of measures Airbus had become number one. In 2002, Airbus had received 233 commercial orders compared to Boeing's 176 orders, representing 57 percent unit market share and an estimated 53.5 percent dollar value market share.6 Airbus Industrie Airbus was understandably proud of its growth. Established in 1970 by a consortium of European companies, it took Airbus 23 years to deliver its first 1000 aircraft, another 6 years to deliver the next 1000 and only another 3 years (2002) to pass the 3000 aircraft milestone.7 In 1999, for the first time in its history, it recorded more plane orders than its rival Boeing. Airbus's large plane commercial aircraft products included the A300/310, A320, A330/340 and A380 family. Airbus touted the A300/310 family as having the flexibility to serve short, medium, and extended-range routes. The widebody twin-engine aircraft was considered midsize with a typical passenger configuration of about 250 passengers. This family first flew passengers in 1983 and it was this aging fleet that provided a replacement opportunity for Boeing's 7E7. However, while Boeing was betting on the future demand for midsized aircraft, Airbus had announced its A380, superjumbo four-engine jet in 2000. The A380 was due to fly in 2006 with a 550-passenger configuration and long distance range of up to 8000 miles. It would be the largest passenger aircraft ever built. The Boeing Company Boeing was split into two primary segments: Commercial Airplanes and Integrated Defense Systems. In 2002 it was awarded $16.6 billion in defense contracts second only to Lockheed Martin with $17.0 billion. Exhibit 1 shows that in 2002 each segment earned Boeing's revenues almost equally. In addition, while commercial aircraft revenues had been falling, 5 \"Losing Ground to Airbus, Boeing Faces a Key Choice,\" Wall Street Journal April 21, 2003. 2002 Commercial Results, www.airbus.com/ 7 In 2001 Airbus formally became a single integrated entity through the transfer of Airbus related assets to the newly incorporated company owned 80 percent by EADS (European Aeronautic Defense and Space Company) and 20 percent by BAE systems. 6 -4- UVA-F-1449 defense revenues had been rising. Analysts believed that Boeing enjoyed significant technology transfers from the defense R&D to the commercial aircraft segment. The commercial aircraft segment produced and sold six main airframes designed to meet the needs of the short to long-range markets: the 717, 737, and 757 standard-body models, and the 747, 767 and 777 wide-body models. As of December 31, 2002, Boeing had undelivered units under firm order of 1083 commercial aircraft and a declining backlog of about $68 billion. For 2003 they projected 280 commercial aircraft deliveries and between 275 and 300 in 2004. Boeing estimated that the revenues for its commercial airplanes segment in 2003 would be approximately $22 billion, down from $28 billion in 2002. Recognizing the negative impact of the September 11 attacks on commercial aircraft demand, Boeing cut the production rates for 2002 in half and was able to maintain profitability in the segment. Exhibits 2 and 3 show Boeing's balance sheet and income statement respectively. While Boeing's earnings were down significantly from 2001 to 2002, most of this was the result of an accounting change (SFAS No. 142). However, also contributing to the decline was a drop in commercial airplane deliveries from 527 in 2001 to 381 in 2002. Demand for Commercial Aircraft The long-term outlook for aircraft demand seemed positive.8 Boeing's Market Outlook said: In the short term, air travel is influenced by business cycles, consumer confidence, and exogenous events. Over the long-term, cycles smooth out and GDP, international trade, lower fares, and network service improvements become paramount. During the next 20 years, economies will grow annually by 3.2 percent, and air travel will continue its historic relationship with GDP by growing at an average annual rate of 5.1 percent. As shown in Exhibit 4, Boeing's 20-year forecast from 2003 to 2022 was for 24,276 new commercial aircraft valued at $1.9 trillion in 2002 U.S. dollars. The company predicted a composition of 4,303 smaller regional jets (fewer than 90 seats); 13,647 single-aisle airplanes; 5,437 intermediate twin-aisle airplanes, and 889 747-size or larger airplanes. This prediction reflected a world fleet that would more than double with a fourth of the market coming from aircraft replacement and three fourths from projected passenger and cargo growth. Exhibit 5 illustrates Airbus's 20-year predictions for the years 2000-2020. Although the report was dated 2002, because of the September 11 attacks, numbers included the year 2000 to serve as a benchmark year. For this period, Airbus predicted the delivery of 15,887 new 8 The primary sources for commercial aircraft demand estimates include Boeing's 2003 Current Market Outlook and Airbus's 2002 Global Market Forecast 2001-2020. While both reports recognized the negative effects of \"exogenous events\" such as September 11, 2001, they also both agreed on a healthy long-term outlook. -5- UVA-F-1449 commercial aircraft with a value of $1.5 trillion in 2002 U.S. dollars. This included 10,201 single-aisle aircraft; 3,842 twin-aisle aircraft; 1,138 very large aircraft, and 706 freighters. The 15,887-unit forecast did not include planes with less than 90 seats. Although Boeing and Airbus's numbers are not directly comparable due to the slightly different time periods and aircraft classifications, it appeared that Airbus was more optimistic about the market for large aircraft than Boeing. While Airbus predicted this to be a $270 billion dollar market including 1138 passenger units, Boeing projected only $214 billion with 653 passenger units. Boeing however estimated that the share of intermediate-size planes would increase from 18 percent to 22 percent. In their forecast, they acknowledged that intermediatesize airplanes would allow airlines to economically fly the increased frequencies, city pairs, and non-stop flights requested by passengers. According to a recent study by Frost & Sullivan, they believed that the Airbus market projection for the A380 was \"over-optimistic.\"9 Aircraft Development and Life Cycle The development of a new airframe was characterized by huge initial cash outflows that might require between one and two decades to recoup. For example, the development costs for the Boeing 777 were rumored to be $7 billion. Any pricing would not only have to recoup the up-front development costs, but also the production costs. In addition, pricing would be subject to rigorous competitive pressures. In short, because of the financial strains a new product line might create, each new aircraft was a \"bet the ranch\" proposition. Over time, survival in the industry depended on introducing successful products and having the financial \"deep pockets\" with which to survive the cash-flow trough. While aircraft sales were subject to short term cyclical deviations, there was some degree of predictability in sales. Sales would typically peak shortly after the new aircraft introduction and then fall. Thereafter, sales would rise and fall as derivatives of the aircraft were offered. Exhibit 6 shows such cycles for the first 20 years of the 757 and 767 sales. The 7E7 The concept of the 7E7 was driven by customer requirements. Boeing had originally announced in March 2001 its plans to build the Sonic Cruiser, a plane that would fly just below the speed of sound. The success of the Cruiser depended on whether passengers would pay a premium for a faster flight. However, potential airplane customers who had been interested in the Cruiser during a robust commercial air travel market were now focusing on survival. The events of September 11 and the bursting of the technology bubble had led to a significant decline in airplane orders. As a result Boeing solicited updated feedback from a number of potential customers who would soon need to replace their aging fleet of midrange planes such as the 757s, 9 \"An Ongoing Rivalry\