boeing 777 BY ERNITSRI Ryan Perkins, Christopher Aldridge, Travis Johnson, Suzanne Holt Case Study: Boeing 777 Copyright 2010. Gatton Student Research Publication. Volume 2, Number 2. Gatton College of Business & Economics, University of Kentucky FIN 445 October 2010 Gatton Student Research Publication | 1 The purpose of this case study is to determine if Boeing should accept or reject the project of producing their new line of commercial aircraft, the Boeing 777. The aircraft will complete a family of Boeing airplanes that service a broad range of necessities within the commercial airline industry.
Frank Shrontz, the CEO of Boeing, has stated that his goal is to increase the company’s return on equity (ROE) from the recent average of 12%; the 777 project, if accepted, should increase the ROE of the firm. By finding the net present of the projected future cash flows of the project we were able to determine the profitability of the 777. The first step in determining if this is an acceptable project is to find the beta, the risk of the new project, of Boeings commercial component. The beta was calculated by unlevering (removing the financial risk) and averaging the betas of Grumman,
Northrop, and Lockheed, which are three primarily defense-oriented benchmark companies, using the following formula: . The average of these three Value Line betas equaled 0. 5328. We then unlevered the total Boeing beta: =0. 9883, and with the unlevered defense beta, we were able to isolate the unlevered Boeing commercial beta. We used the percentage of Boeing that is comprised of defense (26%), and wit the following formula, determined the Boeing commercial beta: Our next step was to lever the unlevered commercial beta by using a debt to equity ratio of 14%.
We chose to use analysts’ prediction of 14% due to future financing needs if the project were to be accepted. We then needed to find the cost of equity of the project by using the SML Equation: Gatton Student Research Publication | 2 The risk-free rate that we chose was 8. 82%, which was the long-term yield on a treasury bond in 1990. This rate was used because it was the least risky rate when considering a long-term project. The market-risk premium is 4. 5%, 64-year geometric average equity market risk. The cost of equity came out to be 15. 59%. The weighted average cost of capital (WACC) was then solved for: [
The cost of debt used was 9. 73%, which was the average yield to maturity of AArated debt with 5 years to maturity. We used this fgure because if new debt was issued, it would most likely parallel the debt issuance of an AA-rated company. A 34% tax rate and a 14% weight of debt were used. The next step involved was finding the net present value (NPV) of all future cash flows from the project. Based on information gleaned from analyst forecasts, we performed a sensitivity analysis by varying the selling price of the plane from 100-130 million dollars.
Boeing has estimated that the selling price of each plane will be $130 million; however, analysts’ estimates ranged between $100 and $130 million due to competition in the market and political and economic instability (Gulf War and recession of the early 1990’s). While finding the NPV at different price points, we held constant the assumption that depreciation and all other expenses do not vary along with selling price. All cash flows were discounted back to 1990 using the WACC through the following formula: The following table contains the NPV of the project at each respective price:
Selling Price of Plane (in millions) $100 $110 $120 $130 Net Present Value (in millions) -8,070. 29 -4,761. 00 -1,451. 70 1,857. 595 Gatton Student Research Publication | 3 Based on an equal weight for each NPV, one could assume that because of heavily negative NPV outcomes, the project would be rejected. However, we have chosen to accept the project. A significant reason for accepting this project is due to the forecasted demand of the 777. The total commercial airline market is expected to grow to $61 5 billion by 2005. Two-thirds of this growth ($410 billion) is expected in he segment that the 777 will service.
Overall airline traffic is expected to increase by 5. 2%, with an even higher projected growth rate (10. 6%) on the routes targeted by the 777 in Asia. Boeing has historically held 54% of the airline market share. Competing airline manufacturers have begun building plans to target the large bodied aircraft segment. Assuming Boeing translates its historical market share in this growing segment, it should accept the 777 project. With the value of this new market segment paired with Boeing’s strong share, ultimately, the project should increase ROE.
Although accepting the project would lead to initially high R costs, potential benefits could be realized for future projects. Spending on the 777 aircraft could be used to develop other derivative aircraft at a much-reduced cost in the future. This reduced cost would come from existing design and manufacturing processes that develop from this project. The weighted average cost of capital (WACC) used in our sensitivity analysis was a product of analysts’ projections ofa 14% DIE ratio. We feel that this ratio, while acceptable, may be too high given Boeings historical aversion to debt. With a lower
DIE ratio, the WACC would be adjusted lower, thus increasing NPV projections for each level of aircraft pricing. This increase in NPV would only further support our decision to accept the project. Based on the fgures provided and the sound financial structure of the company, we believe that Boeing should accept this project. If accepted, Boeings reputation as an Gatton Student Research Publication | 4 innovative market leader should serve them well in this new market segment, leading to long-term profitability and ultimately, an increase the firm’s ROE. Gatton Student Research Publication | 5