Boeing 777 – A Financial Analysis of New Product Launch Alexis Heideck ● Eduardo Lioy ● Jonas Angeles Keya Williams ● Ritwik Malvi

Case Overview Boeing World’s leading manufacturer of commercial jet aircraft Historical 54% market share 2 principal segments: defense & commercial aircraft Sales of $27 Billion and expected profits of $1.4 Billion in 1990 50% profit increase from 1989 Main competitors: Airbus Industries & McDonnell Douglas Oct 1990 = CEO, Frank Shrontz announces Boeing 777 launch Shrontz’s mission: Raising Boeing’s ROE of 12%

Case Overview Boeing 777 350-390 Passengers International travel Can travel up to 14000 kilometers First delivery in May 1995 $130 million per plane Fastest growing market segment (seats & distance) Expected increase in airline traffic of 5.2% over next 15 years Forecasted 10.6% growth in traffic to Asia Kuwait Invasion Political & economic uncertainties Increase in oil prices and decline in airlines travel

Profitability Measures Improving ROE = Accounting measure of increasing shareholders wealth To improve ROE: a) Increase Net Income b) Reduce Total Book Equity Better measure is CF to shareholders (dividends, capital gains). 777 contribution to CF is relevant. According to projected cash flow: Negative cash flow: First 5 yrs (decrease in ROE) Projected positive cash flows for remainder of project If Boeings projections hold 777 project will significantly increase Net Income, ROE.

Why Is The 777 Important? Meets market need for medium to large aircraft 5.2% annual increase in airline traffic by 2010 350-390 passengers; travels up to 7600 miles Expected sales of 1000 Units in first 10 years Sales price of $100-$130 Million Most Flexible and Cost efficient Fly by wire technology

SWOT Analysis Strengths Weaknesses Boeing has a 50% market share Carry up to 390 passengers ; 7600 miles Fly by wire technology Estimated savings in R&D spending of 20% Involvement from engineering and airlines to ensure customer satisfaction Folding wing tip technology $97 Billion in backorders on aircrafts Only firm order received by United Airlines Large capital expenditures on manufacturing facilities and training (estimated $2.5 Billion) Estimated 10-20 Years to break even Risks of depleting book value of equity if not successful

SWOT Analysis Opportunities Threats Annual Increase in Airline traffic of 5.2% . 10.6% in Asian market Aging Aircrafts - Replacement value of 642 large aircrafts Competition in niche market (Airbus Industries and McDonnell Douglas) Competition may cause decrease in price ($130M to $100M) Unknown length of war Unstable political and economic climate Increase in oil prices – decrease in airline travel and cancellation of orders

Determine Boeing’s WACC To determine the appropriate WACC we used following formula: ( ) t r debt quity WACC - ´ + = 1 V D E e And followed a stepwise approach: (1) Calculate Boeing’s commercial aircraft division b (2) Calculate Boeing’s Cost of Equity (3) Calculate Boeing’s Cost of Debt (4) Calculate Boeing’s WACC

Boeing’s Commercial Aircraft Division b Reference market portfolio selection S&P 500 selected (Boeing listed in S&P 500, index represents a close group of peer large cap US companies) Reference time interval selection 12 months β selected because : 12 months data reflects current market conditions. 58 month data would provide an outdated picture 60 days data strongly biased by short term fluctuations.

Boeing’s Commercial Aircraft Division b Calculate unlevered b’s for three “pure play” defense aviation companies (Grumman, Northrop and Lockheed). equity debt t) - (1 1 levered unlevered + = b

Boeing’s Commercial Aircraft Division b Re-lever the average b to reflect Boeings capital structure and obtain Boeings defense division b. Calculate Boeings commercial aircraft division b using following relationship: b commercial = 1.719 ( ) 376 . 0.018 0.34) - (1 1 372 equity debt t) defense = ´ + ÷ ø ö ç è æ unlevered b commercial defense b ´ + = Boeing %

Determine Cost of Equity From Boeing’s defense division b we can calculate the cost of equity using the Capital Asset Pricing model. Risk free rate = 8.82 % (long-term U.S Treasury Bonds) Market risk premium = 5.4% (64 year geometric average equity-market risk premium) % 10 . 18 719 1 .054) ( 0882 ) - e = ´ + commercial free market quity r b

Determine Cost of Debt Estimate cost of debt using market rates of Boeing’s corporate bonds. Boeing’s long-term debt consist entirely of two bond issues Calculate weighted average of the market rate these two issues to arrive at a combined rdebt: 2 1 bond bond2 bond1 V debt r ´ + = % 67 . 9 0931 37 5 234 .0973 234.5 = ´ + debt r

Weighted Average Cost of Capital (WACC) debt quity WACC - ´ + = 1 V D E e Insert values for rdebt, requity and the relative equity and debt proportions: ( ) % 89 . 17 34 1 67 9 271.5 14896.76 18.10% = - ´ + WACC r % 89 . 17 = WACC r

Impacts of Economic Climate and Impending War Long Term Impacts β is a weighted sum of β’s for each division: Changes in revenue from each division will affect β of each division Factors affecting Commercial Division’s β: Long-Term economic growth due to war spurring commercial air travel Factors affecting Defense Division’s β: Increased demand for and spending on defense products by government due to war

Impacts of Economic Climate and Impending War Short Term Impacts Events in Kuwait led to increase in fuel prices Increased expenditure for airlines leads to price increases for customers Temporary dip in passenger air traffic Temporary decrease in demand for Boeing’s commercial division Since the Boeing 777 project is 35 year long project, long-term impact is more relevant

Revenue/Cost Scenarios & Project Profitability Key Assumptions Key Assumptions Impacting Cash Flow: Revenue Assumptions: Sales Price Sales Volume Expenditure Assumptions: R&D (as % R&D Expense / Sales) GS&A (as % GS&A Expense / Sales)

Revenue/Cost Scenarios & Project Profitability Sensitivity Analysis Revenue Assumptions: Sales Volume and Sales Price Extreme Low Expected Extreme High Sales Volume (Units) 700 1000 1200 Sales Price ($ Millions) $100 $130 IRR 13.9% 18.9% 20.6% WACC = 17.894 %

Revenue/Cost Scenarios & Project Profitability Sensitivity Analysis Expenditure Assumptions:%R&D/Sales and %GS&A/Sales Extreme Low Expected Extreme High % GS&A/Sales 7 4 1 % R&D/Sales 5 3 IRR 13.5% 18.9% 23.5% WACC = 17.894 %

Revenue/Cost Scenarios & Project Profitability Assumptions and Real World Forces Revenue Assumptions: PESSIMISTIC Impact Sales Price: McDonnell Douglas/Airbus Industries competition (Sales Price = $100M) Sales Volume: High gas price reduces demand to 700 units Expenditure Assumptions: OPTIMISTIC Impact R&D: Boeing could leverage defense knowledge (R&D reduced by 20% = $3.2-$4M or 2.6% R&D Expense/Sales) GS&A: None specified, assume at baseline (GS&A = 4%)

Revenue/Cost Scenarios & Project Profitability Revenue Assumptions: Pessimistic Pessimistic Sales Price = $100M Pessimistic Sales Volume = 700 units Pessimistic Price Only Pessimistic Volume Only Pessimistic BOTH Expected Sales Volume (Units) 1000 700 Sales Price ($Millions) $100 $130 IRR 16.1% 16.3% 13.9% 18.9% WACC = 17.894 %

Revenue/Cost Scenarios & Project Profitability Expenditure Assumptions: Optimistic Optimistic %R&D Expense/Sales = 2.6% Optimistic assumes baseline GS&A at expected = 4% Optimistic %R&D Expense/Sales Expected % GS&A/Sales 4 % R&D/Sales 2.6 3 IRR 19.5% 18.9% WACC = 17.894 %

DCF Analysis of Boeing 777 DCF Analysis supports Boeing 777 Project IRR = 18.9 % (expected case) > WACC = 17.894 % Real World Forces may impact Key Assumptions, however some Pessimistic Forces likely Short Term Revenue Assumptions – PESSIMISTIC Expenditure Assumptions – OPTIMISTIC

Limitations of DCF Method DCF Analysis of Boeing 777 Limitations of DCF Method Static Model Static assumptions projected for entire project – unrealistic Real World Factors create uncertainty in modeling: External Threats (including competitive landscape) Interaction/Interdependence of divisions/projects on one another Organizational Learning/Efficiency, Reduced Expenses Over Time Sunk Costs The Boeing 777 Case Specifically: Competition and sales Organizational learning and R&D expense Ignores sunk costs of R&D expenses prior to October 1990

Recommendations Continue to innovate and invest Need to update fleet and replace aging products Decide which investment is correct: Boeing’s 777 fills a gap and serves a fast-growing Asian market 777 project IRR’s range from 13.6% (pessimistic) to 23.6% (optimistic) while discount rates range from 10% - 20% Project IRR exceeds baseline discount rate The above data supports the strategic advantages of investing in the Boeing 777 launch

Thank You Alexis Heideck ● Eduardo Lioy ● Jonas Angeles Keya Williams ● Ritwik Malvi