Four reasons are inherent for Boeing to launch the 7E7 project, which are discussed briefly as follows:
However, the time is not appropriate for Boeing to launch the 7E7 project. This is because technological problems could result in additional risk of failure and the requirement of initial investment is high. Hence, creating a plane flying short as well as long distances needs two different versions of the plane having different wingspans (Bazdresch, Kahn and Whited 2017). In fact, after the 2001 plane crash, there is risk in using the composite materials. Moreover, SARS, Iraq war and international terrorism lead to international travel warnings. Thus, the real market demand was seen as the worst during these years.
a:
Based on the provided case study, the computed IRR has been 15.7%. Hence, the required rate of return need to be equal to at least 15.7%. In case, NPV is greater than zero, the project could be undertaken. On the other hand, if the NPV is less than zero, the project must be rejected. If NPV is equal to zero, the project could be undertaken with utmost caution.
b:
The Capital Asset Pricing Model (CAPM) could be used in estimating the cost of capital of the organisation directly; however, in practice, it is never utilised for that purpose. A true asset beta could not be observed, as the items on the left-hand side of the statement of financial position are not traded ordinarily in liquid markets. In theory, beta could be derived for both debt and equity and they need to be weighed based on the market values of the shares, which would provide a projection for the asset beta of the organisation (Benmelech 2016). Alternatively, the equity beta could be unlevered to derive an asset beta. The insertion of asset beta into CAPM would fetch an estimate of the cost of capital of the organisation. However, these two methods invite error of estimation at a later point of time.
c:
|
Computation of Cost of Equity:- |
||
|
Particulars |
Details |
Units |
|
Risk-free rate |
A |
4.56% |
|
Beta |
B |
1.17 |
|
Market risk premium |
C |
4.30% |
|
Cost of equity |
A + (B*C) |
9.59% |
After looking at the financials of the organisation (NYSE: BA), the computed beta could be found, which is 1.17. Beta is derived by obtaining the financial reports about the organisation, which primarily depicts the fluctuation of Boeing’s stock in relation to S&P index. In other words, if the historical values of the stock of the organisation and S&P index were plotted against each other, beta would be the slope of the best-fit straight line in the graphical data. The risk-free rate is the annual percentage yield of the three-month Treasury bill, which is taken as the standard risk-free rate (Berk et al. 2013).
d:
In the words of Com and II (2016), risk premium is the additional return that the stock of an organisation provides over a risk-free rate. Such return compensates the shareholders for taking on relatively greater risk of the equity market in contrast to the risk-free rate. Hence, in order to compute the same, the expected rate of return is taken from which the risk-free rate is deducted.
Risk premium = Expected rate of return – Risk-free rate = (Dividend yield + Growth rate of dividends) – Risk-free rate = 8.86% – 4.56% = 4.30%. In this case, the growth rate of dividends and dividend yield is collected from the financial ratios and data of the organisation, which is available at finance.yahoo.com. The risk-free rate is the annual percentage yield of the three-month Treasury bill, which is taken as the standard risk-free rate.
e:
According to Exhibit 11 having series of bond with value $393 million, coupon at 6.125% and maturity in 2033 after 30 years have been taken into account. This is because it is the most effective proxy for the project and its time horizon is 30 years as well. The yield on such bond is 5.85%, which is the pre-tax cost of debt of the organisation.
|
Computation of Cost of Debt:- |
||
|
Particulars |
Details |
Units |
|
Pre-tax cost of debt |
A |
5.85% |
|
Tax rate |
B |
35% |
|
After-tax cost of debt |
A * (1-B) |
3.80% |
f:
Debt is subject to defence and commercial risk as well, which denotes the validity of this point. However, this has very little issue compared to equity, since debt is a senior security (Damodaran 2016).
g:
While the CAPM is not limited to instruments of equity in theory and while the beta of every issue of debt is possible to project in case of public trading, solving for the yield-to-maturity of a bond utilising the current market data avoids each assumptions and weaknesses present in CAPM (Flannery and Hankins 2013). The sole reason behind using the CAPM model to estimate equity is that unlike an instrument of bond, in which the principal and coupon payments are known with a fair extent of certainty, the expected cash flows are not known over the potential infinite life of the equity security (Dhaene et al. 2017). Hence, the CAPM model is not used to estimate the cost of debt.
h:
According to the theory, weighted average of each debt risk is a function of the asset risk on the left-hand side of the statement of financial position. However, it would be a debatable situation, if debt risk is sorted further by matching debt maturity to the project length (Ehrhardt and Brigham 2016). At the time of picking the instrument of debt, in which maturity matches the project length, it might be intuitive pleasingly. However, there might be a counterargument regarding the move of Boeing, if it had short-term debt only.
For Boeing, sensitivity analysis discloses little deviation between the two approaches. A weighted average of all debt maturing after or on 2031, would lead to a cost of debt of 6.03%. This contrasts to 5.33% using a weighted average of the available debt information. As a result, this would change WACC from the base case of 16.7% to 16.9%.
i:
From the theoretical perspective, an analyst is needed to use market value by not taking into account the book value weights. According to Exhibit 10, the debt-to-equity ratio or market value for Boeing has been obtained as 0.525. Based on this information, the percentage of debt and equity could be derived (Ferran and Ho 2014). The percentage of debt is provided as 34.4% and the percentage of equity is provided as 65.6%.
a:
|
Computation of WACC:- |
||
|
Particulars |
Details |
Units |
|
Equity beta |
A |
1.45% |
|
Risk-free rate |
B |
4.56% |
|
Expected market return |
C |
11.70% |
|
Cost of equity |
D |
9.59% |
|
Cost of debt |
E |
3.80% |
|
Debt/equity |
F |
0.525 |
|
Weight of debt |
G |
0.344 |
|
Weight of equity |
H |
65.60% |
|
Tax rate |
I |
35% |
|
WACC |
(D*H)+E*(1-I)*G |
7.14% |
Most of the organisations compute WACC for providing the investors a projection on profitability along with the ability to weigh future projects. For computing the WACC, the current bonds of Boeing including the long-term debt portion of capital and the assets of Being comprising of the equity portion of capital have been taken into consideration (Foley and Manova 2015). However, other weighted entities like preferred shares are not taken into consideration for the calculation of WACC. The debt/equity ratio would enable in calculating weights. Boeing would require earning at least 15.443% return on investment for maintaining the actual share price.
b:
There are various circumstances for an economically attractive project and they are described as follows:
Sale of airliners:
This project would be attractive from the economical perspective, if Boeing could sell adequate number of planes within limited timeframe beyond a certain price. The internal rate of return or the hurdle rate that provides NPV of zero is 15.7%. This implies that Boeing needs to sell a minimum of 2,500 airliners within the initial 20 years at 0% price premium or higher for this project for enhancing the overall wealth of the shareholders.
Market demand:
The US had some of the lowest number of passengers in the recent history. A reverse of such trend is vital in reaching some of the estimated revenue numbers, which Boeing is counting on. Several influential dynamics are inherent to such lower numbers (Fracassi 2016).A fall in business travel had taken place because of cost and the development of conferencing technologies. Finally, the weak economy had vacationers planning to visit local destinations rather than travelling abroad.
Market share:
The strongest rival of Boeing is Airbus. It is important that the new 7E7 meets its commitment of lower operational cost. This would enable in capturing greater market share (Gullifer and Payne 2015). It would become highly significant; in case, the economy failed to recover quickly in accordance with the expectations. The other aspects of the success of 7E7 denote the engineering associated with an expandable wing. By adding this versatility, the owner of 7E7 would provide greater options for travel routes.
c:
The intention of sensitivity analysis is to obtain cash flows in relation to the overall project variables. Boeing had to ascertain the underlying variables, which are the development costs in this case and per-copy costs in forming 7E7. Depending on the above sensitivity analysis, it denotes that the nature of gamble of Boeing on the 7E7 is high. Based on the provided case information, it is anticipated that the development costs would be $8 million with a base case assumption of 80% in the form of percentage of cost of sales to sales. This would fetch an IRR of 15.7%; however, if the costs had been $10 million with 84% assumption, the IRR would be 8.6%. Hence, the gamble is greater due to the swing of the development costs to $4 million and the variance of IRR to 12.7.
After careful consideration of the benefits and risks of the 7E7 project, it is recommended to the Board of Directors to carry on with the project. However, there are some inherent risks involved in this project, which arise from the materials used and design (Hillier et al. 2013). The 7E7 is the first plane in using a construction of carbon body along with employing wingtip extenders. This would include risk to the project, as they had not been used on such a big scale project.
The supply chain is extremely large and spread around the world. This would result in challenges handling this contract network. Various parts of the plane are constructed entirely in other nations and then sea is used as means for shipping them to the Seattle facility of Boeing for the final assembly. As a result, the inherent risk of the project would be increased, if any contract did not deliver on time (Lerner and Seru 2017).
One of the close competitors of Boeing is Airbus. They had planned to introduce new A380 in 2005 in the market. This plan would pose intense competition on 7E7. In case, Boeing fell behind in relation to fuel efficiency, innovation and the other attributes of a long-haul airliner, it would lose its share in the market. For Boeing to keep up with the industrial competition, some risks need to be taken and it needs to form this new plane. In addition, the volatility of the economy has compelled the airlines to search for option in order to minimise their operating costs (Scholes 2015). The 7E7 would carry additional passengers per flight in a way, which is fuel-efficient and it enables the airlines to justify buying the plane. The success associated with the expandable wing would provide attractive versatility to the plane.
In order to increase the wealth of the shareholders, Boeing could sell a minimum of 2,500 aircrafts over 20-year period at the time of keeping development costs at or below $8 billion and cost of sales as percentage of sales below or at 80%. In case of cost overruns, the cost of sales as a percentage of revenue needs to stay lower than or at 78%, as per Exhibit 9.
The risk premium of the equity market needs to be identical to the excess return, which the investors expect on the market portfolio. In this case, the market risk premium is obtained as 4.30%. The weighted average cost of capital has been obtained as 7.14%. As the estimated revenues listed on Exhibit 8 are well-behaved, the IRR tables could be trusted listed on Exhibit 9. For the project to raise the wealth of the shareholders, the WACC should be equal to the hurdle rate of the project (Vernimmen et al. 2014). For accomplishing the same, Boeing would have to sell a minimum of 2,500 airliners within a 20-year period. Boeing had expected to reach this unit goal.
As provided in the report, the financial computations depict a high probability for the project to raise the wealth of the shareholders. The other risks are discussed above, which need to be taken into consideration. However, on balance, the reasons to progress ahead with the project outrun those against it.
References:
Atanasov, V. and Black, B., 2016. Shock-based causal inference in corporate finance and accounting research.
Avdjiev, S., McCauley, R.N. and Shin, H.S., 2016. Breaking free of the triple coincidence in international finance. Economic Policy, 31(87), pp.409-451.
Bazdresch, S., Kahn, R.J. and Whited, T.M., 2017. Estimating and testing dynamic corporate finance models. The Review of Financial Studies, 31(1), pp.322-361.
Benmelech, E., 2016. Discussion of Patrick Bolton’s “Corporate Finance, Incomplete Contracts, and Corporate Control”. In The Impact of Incomplete Contracts on Economics. Oxford University Press.
Berk, J., DeMarzo, P., Harford, J., Ford, G., Mollica, V. and Finch, N., 2013. Fundamentals of corporate finance. Pearson Higher Education AU.
Com, M. and II, S., 2016. International Finance.
Damodaran, A., 2016. Damodaran on valuation: security analysis for investment and corporate finance (Vol. 324). John Wiley & Sons.
Dhaene, J., Hulle, C., Wuyts, G., Schoubben, F. and Schoutens, W., 2017. Is the capital structure logic of corporate finance applicable to insurers? Review and analysis. Journal of Economic Surveys, 31(1), pp.169-189.
Ehrhardt, M.C. and Brigham, E.F., 2016. Corporate finance: A focused approach. Cengage learning.
Ferran, E. and Ho, L.C., 2014. Principles of corporate finance law. Oxford University Press.
Flannery, M.J. and Hankins, K.W., 2013. Estimating dynamic panel models in corporate finance. Journal of Corporate Finance, 19, pp.1-19.
Foley, C.F. and Manova, K., 2015. International trade, multinational activity, and corporate finance. economics, 7(1), pp.119-146.
Fracassi, C., 2016. Corporate finance policies and social networks. Management Science.
Gullifer, L. and Payne, J., 2015. Corporate finance law: principles and policy. Bloomsbury Publishing.
Hillier, D., Ross, S., Westerfield, R., Jaffe, J. and Jordan, B., 2013. Corporate finance. McGraw Hill.
Lerner, J. and Seru, A., 2017. The use and misuse of patent data: Issues for corporate finance and beyond (No. w24053). National Bureau of Economic Research.
Scholes, M.S., 2015. Taxes and business strategy. Prentice Hall.
Vernimmen, P., Quiry, P., Dallocchio, M., Le Fur, Y. and Salvi, A., 2014. Corporate finance: theory and practice. John Wiley & Sons.
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