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BOEING 7e7

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The Boeing 7E7

Abstract
Boeing Company has remained a market leader in the aircraft manufacturing industry with only
Airbus as its chief competitor since decades. The company had successfully launched 777 and
737 aircrafts in the past, and both of these projects had been very successful. However, since
1994, after the introduction of Boeing 737, no new commercial jet was introduced by the
company until 2003, when the company decided to launch Boeing 7E7, which was subsequently
called as “Dreamliner”. Boeing 7E7 was capable of carrying 200-250 passengers at a cost that
was less than 10% of the costs of a commercial jet of a similar capacity i.e. Airbus A300/200.
This cases analysis discusses the financial feasibility of the project to see if it is worthwhile for
all the stakeholders, particularly shareholders, to take the risk of launching this commercial jet.

1. What is an appropriate required rate of return against which to


evaluate the prospective IRRs from the Boeing 7E7? Please use the
capital asset pricing model to estimate the cost of equity. At the date of
the case, the 74-year equity market risk premium (EMRP) was
estimated to be ___. Which beta and risk-free rate did you use? Why?
In order to do the feasibility analysis of the project, the first step is the calculation of WACC.
With the help of WACC, there can be find out the NPV of the project or find out the IRR of the
project and see if it is economically feasible for the company to launch the project.

The formula for the calculation of weighted average cost of capital is as follows:

WACC = weight age of debt*(rd)*(1-t) + Weight age of equity *(Re)

The cost of debt, Rd, can be calculated using the data given in the exhibit 11 of the case. Exhibit
11 of the case shows the amount of debt, coupon rate, maturity date, price and YTM. In order to
calculate the cost of debt using this information, weighted average yield to maturity has to be
calculated first. Calculations in the excel sheet show that the total market value of debt comes
out to be $5,022.12 million. The next step is to divide the market value of each individual debt
instrument and then multiply the result with the YTM (yield to maturity) of that instrument. The
sum of this weighted average yield to maturity values gives the cost of debt for the company.
Calculations carried out in the excel sheet show that the sum of weighted average YTM values
comes out to be 5.335%.

Data from exhibit 10 of the case can be used to find out the cost of equity for the firm. It is better
to use 60 months beta values of Boeing and the comparable companies because of the long term
nature of the project. Using the NYSE composite index values, the following formula can be
used to find out the values of unlevered beta for the all the companies using 60 months levered
beta data.

Unlevered Beta = Levered Beta/ (1+ (1-t) D/E)

The tax rate for Boeing has been given as 35% while the ratio of debt to equity market values has
been given as 52.5%. So,

Unlevered Beta (Boeing) = 1/ (1+ (1-35%) 52.5%) = 0.7455

Similarly, effective marginal tax rate for Lockheed Martin has been given as 35% while the ratio
of market value of debt to equity has been given as 41%. So,

Unlevered Beta (Lockheed) = 0.49/ (1+ (1-35%) 41%) = 0.387

Effective marginal tax rate for Northrop Grumman has been given as 35% while the ratio of
market value of debt to equity has been given as 64%. So,

Unlevered Beta (Northrop) = 0.44/ (1+ (1-35%) 64%) = 0.311.

The average of these two beta values comes out to be 0.349. This value will be used as a proxy
for Unlevered Beta (Boeing-defense) because both the companies, Lockheed and Northrop,
operate mainly in the defense market. The unlevered Beta-commercial for the Boeing Company
can be calculated using the following formula:

Unlevered Beta (Boeing) = % of commercial business*Unlevered beta commercial + % of


defense business*Unlevered beta defense

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Exhibit 10 shows that 46% of the sales of the Boeing Company consist of defense supplies while
the remaining 54% consist of commercial supplies.

Unlevered Beta-Boeing commercial = (0.7455 – 46%*0.349)/54% = 1.084

Levered Beta- Boeing Commercial = 1.084*(1+ (1-0.35)*52.5%) = 1.453

Risk free rate of return has been given in the case as 4.56% while the risk premium has been
given as 8%. So, cost of equity, Re can be given as follows:

Re = 4.56% + 1.453*(8%) = 16.19%. So based on this cost of equity, WACC can be calculated
as follows:

WACC = rd*(1-t) Weight age of Debt + re* Weight age of equity = 5.335%*34.4 %*( 1-0.35) +
65.5%*16.19% = 12.52%

Similarly, Using the S&P index values, the values of unlevered beta for all the companies using
the 60 months levered beta data can be computed using the following equation.

Unlevered Beta = Levered Beta/ (1+ (1-t) D/E)

The tax rate for Boeing has been given as 35% while the ratio of debt to equity market values has
been given as 52.5%. So,

Unlevered Beta (Boeing) = 0.8/ (1+ (1-35%) 52.5%) = 0.525

Similarly, effective marginal tax rate for Lockheed Martin has been given as 35% while the ratio
of market value of debt to equity has been given as 41%. So,

Unlevered Beta (Lockheed) = 0.36/ (1+ (1-35%) 41%) = 0.255

Effective marginal tax rate for Northrop Grumman has been given as 35% while the ratio of
market value of debt to equity has been given as 64%. So,

Unlevered Beta (Northrop) = 0.34/ (1+ (1-35%) 64%) = 0.207

The average of these two beta values comes out to be 0.231. This value will be used as a proxy
for Unlevered Beta (Boeing-defense) because both the companies, Lockheed and Northrop,

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operate mainly in the defense market. The unlevered Beta-commercial for the Boeing Company
can be calculated as follows:

Unlevered Beta-Boeing commercial = (0.525 – 46%*0.231)/54% = 0.774

Levered Beta- Boeing Commercial = 0.774*(1+ (1-0.35)*52.5%) = 1.181

The cost of equity, Re can be given as follows:

Re = 4.56% + 1.181*(8%) = 14.01%. So based on this cost of equity, WACC can be calculated
as follows:

WACC = rd*(1-t) Weight age of Debt + re* Weight age of equity = 5.335%*34.4 %*( 1-0.35) +
65.5%*14.01% = 10.43%.

Exhibit 9 of the case shows that the Internal Rate of Return for the Boeing Company is 15.7%.
Both of these WACC values calculated above using two indices are less than the IRR value. This
means that the project for 7E7 will generate positive NPV. Both the IRR and NPV techniques
show that the board should approve the project because it has a positive net present value.

2. When you used the capital asset pricing model, which risk-premium and
risk-free rate did you use? Why?
The month Treasury bill rate (4.56%) was used as the risk free rate and the risk premium of 8%
were used for the calculation of cost of equity using CAPM. The 30-year Treasury bond rate
(4.56%) and the risk premium have been mentioned in the exhibit 10 of the case study. Since the
project is of a long term, 30-year Treasury bond rate has been used as a proxy for the risk free
rate. Estimate for the equity market risk premium has been given in the case as 8%.

3. Which capital-structure weights did you use? Why?


As shown in the calculations of WACC in the first question, capital structure weights used for
debt and equity are 34.4% and 65.5% respectively. Debt weight has been derived by dividing the
market value of debt by the sum of market values of debt and equity. The weights for equity can

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simply be calculated by subtracting weights for debt from 100%. These weights were used to
calculate the overall cost of capital acquired by the company through different sources.

4. Should the board approve the 7E7?


Financial analysis shows that the board of directors should approve the project because the Net
present value of the project is positive. However, there are many other factors that need to be
considered in order to understand the true implications of the project. Boeing 7E7 is the first
plane of its kind to use carbon body construction. This risk factor has not been incorporated in
the calculation of WACC because it is too subjective to estimate. However, the board should
take this factor into account before making its decision. These risks and returns associated with
being the first to use this technology are immense. If the project succeeds, then the first mover
advantage will enable the company to reap financial benefits; however, at the same time no
proven precedent of this technology being used in the past indicate a level of riskiness.

Another aspect that the board needs to consider, in addition to the financial analysis, is the
supply chain management. The spare parts of the being 7E7 will be manufactured in different
countries and then shipped to the assembling facility in USA. Therefore, the board needs to make
sure that the supply chain management of the company is sound and able to meet the challenges.

A challenge that Boeing 7E7 needs to consider is that Airbus is expected to launch A380 in the
near future which is expected to exhibit the same level of fuel efficiency as by Boeing 7E7.
Therefore, board of directors of Boeing should take into account this aspect that whether the
sales forecast will be realized considering the fierce competition that Airbus A380 is expected to
offer. If the board does not approve the 7E7 project, Airbus may take advantage of this situation
by launching comparable products with similar cost efficiency.

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