Case Study:
The Boeing 7E7
Finance
The Rate of Return
We feel that a required rate of return of 3.38% is an appropriate rate of return against which to evaluate the prospective IRRs from the Boeing 7E7 project. This 3.38% figure is the weighted average cost of capital (WACC) that we have estimated for Boeing’s airplane manufacturing division.
In order to estimate this figure, we first had to determine which proxy betas to use and then unlever them. We decided on the 60 month betas regressed against the S&P 500 index. While research has suggested that a three year average is typically best, we felt that a longer period of time will give us more accurate figures given the macroeconomic conditions, such as terrorism and a slumping stock market, that impacted the betas of the next best option, the 21 month period. Using a longer time period would mitigate some of those effects by taking in to consideration more pre-9/11 data points. We chose the S&P 500 index figures as opposed to the NYSE composite figures because, as a very large cap company, we thought it was best to compare Boeing to 500 of its closest peers in terms of size, revenues and reach instead of all 2000 stocks in the NYSE composite.
The formula for unlevering beta requires a debt beta estimate. We feel it is a safe assumption that a large, publicly traded corporation such as Boeing would have a relatively low debt beta because it most likely only invests in investment grade corporate bonds and high quality government bonds. We arrived at our 0.01 debt beta estimate by averaging the betas of various investment grade corporate bond ETFs and government bond ETFs whose holdings we felt would be representative of the bonds Boeing would hold. The formula for unlevering beta also requires a tax rate. We felt that it was best to use the 35% effective marginal tax rate mentioned in the case as this was unlikely to change much year over year. Once all of the proxy betas were unlevered, they were weighted by their percentage of revenues that came from their non-government businesses. This was done so that proxy betas for companies who derive more of their revenues from non-governmental ventures, such as airplane manufacturing, were given more weight than companies who derive more of their revenues from governmental business, such as space and defense.
This figure was then relevered. When relevering, we used a slightly higher debt to equity ratio of 0.6. We thought that the debt to equity ratio would increase from its current 0.525 as Boeing borrows cash to finance the development of the 7E7. However, we don’t think that Boeing will have to borrow much as they have over $2 billion in cash on hand as of 2002 and are able to utilize much of the research and development already conducted by their defense and space business units, hence the slight increase in the ratio. Now that we’ve calculated the levered beta, we estimated the cost of equity and debt using the CAPM formula. For our risk free rate we utilized the 30-year Treasury bond of 4.56%. We chose this so that the 30-year period of our risk free rate would closely match the time horizon of the investment Boeing is making in to the 7E7. Our market return, 5.79%, was the average returns of the S&P 500 index going back 5 years. This was chosen to match the time period and index of our proxy betas. The resulting market premium is 1.23%. Finally, we used these estimated cost of equity and debt figures to calculate the weighted average cost of capital. The only new inputs to this formula were the debt to asset ratio and the equity to asset ratios, both of which were calculated using the information available in the 2002 balance sheet in Exhibit 2 of the case. The resulting WACC, 3.38%, is the absolute minimum return that the Boeing 7E7 project needs to realize in order to make the venture a profitable one. See Exhibit A for calculations and estimations.
While we feel our recommendations are solid, we may face difficulties in implementing them in the form of macroeconomic events that could have a negative impact on our estimations. For example, if market conditions worsen, our beta estimates may be lower than they should. Additionally, if the economic uncertainty continues, Treasury prices will rise, lowering their yields, making financing more expensive. Lastly, if terror attacks continue to hamper travel, there may not be sufficient demand for our new planes.
Exhibit A
Bd
0.01
Proxy beta
Rev from gov
D/E
Unlevered B
Weighted by gov rev.
Boeing
0.8
46%
52.5%
0.80
0.43
Lockheed
0.36
93%
41.0%
0.53
0.04
Northrup
0.34
91%
64.0%
0.58
0.05
Raytheon
0.43
73%
62.4%
0.66
0.18
0.70
B levered
0.97
CAPMe
0.058
CAPMd
0.046
WACC
3.38%
The Internal Rate of Return
IRR rule states that we should undertake the project when its internal rate of return is greater than the project’s cost of capital. In this case, the estimated weighted average cost of capital (WACC) is 3.38%, while having an IRR normally greater than our WACC so that we should undertake this project.
Sensitivity analysis can help estimate how far can IRR go if uncertain risk happens. In this case, we used one-at-a-time (OAT) approach for sensitivity analysis (Exhibit B), which gave us elementary effects and variances for the input parameters. We deemed the number of deliveries is the key driver of IRR since there is great amount of uncertainty in delivery as stated in the course pack that “the events of 911 and the bursting of the technology bubble led to a significant decline in airplane orders.” Other factors are development cost, which could skyrocket and hurt IRR, and price of airplane, that “any uncertainty in the 7E7 plane specifications and risk of competition clearly put downward pressure on both the price Boeing could demand, as well as the number of units it would be able to sell.” (Course Pack)
WACC should be viewed against various possible scenarios but we can gain the big picture of Boeing's gamble through the sensitivity analysis. For example, we assume any scenario that causes IRR above 3.38% is ideal for the project so that the minimum required deliveries, while all other parameters hold at initial values, is 515 units. However, the statement that “Boeing projected a demand for between 2000 and 3000 planes of the 7E7 type within 20 years of each one entering service. A study by Frost&Sullivan predicted the sale of ‘at least 2000 B7E7s.’” gives us a strong belief that the sale of 7E7 will be at least 2000, which, in turn, provides an IRR of 13.49%, while all other parameters hold at initial values. This gives us the insight that if Boeing failed to deliver enough number of planes to reach economic of scale, this project is very likely to fail.
Exhibit B
Sensitivity Analysis
Parameter 1: The number of delivered planes
Deliveries
IRR
0
-16.63%
100
-4.58%
250
-0.70%
515
3.37%
1000
7.78%
2000
7.78%
Parameter 2: Development cost 2004-2009
Development Cost
IRR
$8,000,000,000
7.78%
$9,200,000,000
6.78%
$10,580,000,000
5.81%
$12,167,000,000
4.89%
$13,992,050,000
4.01%
Assumptions: Benchmark: Development cost of Airbus A320 - $2.8B in 1984, A380 - $15B in 2015
In 2007 US dollar value: A320 - $4.42B, A380 - $12.8B
Thus estimate IRR under several development costs with 15% increase from $8B to almost $14B
The 7E7 project, if successful, could ultimately lead to not only Boeing’s financial success, but would also contribute to intangible gains as well. The project’s complexity and riskiness underline the Boeing management team’s ability to foresee consumer demands, and to design, and see through the production and launch of an aircraft that will establish Boeing as a leader in the market for the foreseeable future. The management team’s savviness will be reinforced by their ability to launch the aircraft through a time of extreme economic and political tumult caused by 9/11 and ongoing terrorist attacks. In addition, we foresee Boeing experiencing an overall gain in brand perception due the 7E7’s unique nature compared to its competition. The aircraft’s energy efficiency, the material it is constructed with, and the enhanced in-flight experience will bolster Boeing’s perception in the market as an innovator in the airline space. Overall, we anticipate that Boeing will enjoy significant intangible gain in the form of “market perception” by not only airlines who will be purchasing the 7E7, but also by individual consumers who will be riding them in the future.
