Assignment II - Boeing 777 Case Study Team I

Assignment 2 - Boeing 777 Case study

21st January, 2016

Submitted by Team I

- Illy WEDDERBURN
- Samantha Zhiwei ZUO
- Marco TRADA
- Arnaud SAVIGNAT
- Rohit PARNERKAR
 Assignment II - Boeing 777 Case Study Team I

Q. Should Boeing have launched the 777 in October 1990?

In light of Boeing's CEOs goal of improving theirs ROE, we need to assess whether this new
project would help him pursue his objective. To assess the worthiness of the project we need to
identify if the rate of return from the 777 project and compare it with our Cost of Capital (Equity +
Debt). As the gulf war is not expected to last beyond 6 months hence, we have calculated the long
term viability of the project and have considered a time horizon of 54 months.

The case says that the Inter Rate of Return (IRR) for Boeing is IRR is 19%. If our Cost of
investment is less than IRR we should go ahead with the project. The Prevailing Tax rate is 34%.

To calculate the Cost of Capital the formula is as following:

𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
𝑊𝐴𝐶𝐶 = ( ∗ 𝑅𝑒𝑡𝑢𝑟𝑛𝑒𝑞𝑢𝑖𝑡𝑦 + ∗ 𝑅𝑒𝑡𝑢𝑟𝑛𝑑𝑒𝑏𝑡 ) ∗ (1 − 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒𝑐𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 )
(𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡) (𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 + 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦)

Where Returns on Equity is given by,

𝑅𝑒𝑡𝑢𝑟𝑛𝑒𝑞𝑢𝑖𝑡𝑦 = (𝑅𝑒𝑡𝑢𝑟𝑛𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 + 𝐵𝑒𝑡𝑎𝐵𝑜𝑒𝑖𝑛𝑔 ) ∗ (𝑅𝑒𝑡𝑢𝑟𝑛𝑚𝑎𝑟𝑘𝑒𝑡 − 𝑅𝑒𝑡𝑢𝑟𝑛𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 )

And return on debt is given by,

𝐷𝑒𝑏𝑡𝑇𝑟𝑎𝑛𝑐ℎ1⁄ 𝐷𝑒𝑏𝑡𝑇𝑟𝑎𝑛𝑐ℎ2⁄
𝑅𝑒𝑡𝑢𝑟𝑛𝑑𝑒𝑏𝑡 = ( 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 ∗ 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒𝑇𝑟𝑎𝑛𝑐ℎ 1 ) + ( 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 ∗ 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒𝑇𝑟𝑎𝑛𝑐ℎ 2 )

As a note on Beta, it must me mentioned that we think that NYSE Compost is the best
representation for the market and hence we have used those set of numbers to calculate tested
Boeing’s sensitivities.

Further, as a part of observation we must mention that majority of Boeings revenues come
from commercial activities (74%). it must observed that the firm has extremely low level of Debt, as
evident from the Debt-Equity ratio. Thus the final impact of the Defence division on overall Boeings
Sensitivity to market is not significant. We have used the Beta Estimate of Boeing with respect to
NYSE Composite.

𝑅𝑒𝑡𝑢𝑟𝑛𝑒𝑞𝑢𝑖𝑡𝑦 = 8.82% + 0.87 ∗ (5.40%) = 13.5%

𝑅𝑒𝑡𝑢𝑟𝑛𝑑𝑒𝑏𝑡 = ((234.5 𝑚𝑛⁄271.5𝑚𝑛) ∗ 9.73%) + ((37𝑚𝑛⁄271.5𝑚𝑛) ∗ 9.31%) = 9.67%

14896.7 271.5
𝑊𝐴𝐶𝐶 = (( ) ∗ 13.5% + ( ) ∗ 9.67% ) ∗ (1 − 34%) = 13.90%
15168.26 (15168.26)

As Discussed earlier we will accept the project if our cost of capital is lower that the internal rate of
Return which is projected at 19%. Thus comparing the Findings we see that the project is worth
undertaking in long run as our IRR > WACC (After tax) i.e. 19% > 13.90%

An further Analysis of Sensitivity & Stress Metrix (Exhibit 7). Reviles that the firm will have to
maintain a lower General, Administrative & Sales Expenses (GA&S), while controlling the spending
on Research & Development (R&D) keeping in mind its competitors in commercial space.
 Assignment II - Boeing 777 Case Study Team I

Sensitivity Analysis (IRR)

Worst Case Expected IRR Best Case
Unit volume 700 1100 1200
Price 110 120 130
IRR 14.80% 18.90% 20.60%

GS&A & R&D as percentage of Sales

1% 3% 5%
1% 23.50% 21.80% 19.90%
4% 20.50% 18.90% 16.90%
7% 17.90% 15.80% 13.50%

The project seems to be attractive in the long term as WACC (13.90%) is lower than IRR
(19%), further the gulf war is expected to have only a short term impact, and hence Boeing should
be accept the project.

In addition, Due to competition the price of 777 is expected to be scaled down from $130mn
per aricraft, but as per our analysis it should not be scaled down below $110mn per aircraft as it
would negatively affect the earnings.

As a recommendation Boeing can explore areas unaffected by Gulf war such as the Asia-
Pacific markets. It should also try and simplify & standardise internal processes to bring down costs.