Economy & Finance

Boeing 7E7 a financial analysis

1. - Vishal Prabhakar - Jayaraj Somarajan - Ajay Gnanashekaran - Shafrin Maredia     2. Table of Contents   Sl.No Contents Page 1. Evolution of Project Boeing 7E7 1 2.…
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  • 1. - Vishal Prabhakar - Jayaraj Somarajan - Ajay Gnanashekaran - Shafrin Maredia    
  • 2. Table of Contents   Sl.No Contents Page 1. Evolution of Project Boeing 7E7 1 2. Empirical Data 4 3. 7E7 Project NPV –DCF Analysis 5 4. WACC Calculation 7 5. Payback Period 11 6. Stock Options 12 7. @ Risk Analysis 22 10. Conclusion 23 11. References 24                              
  • 3. Table of Tables Table Number Content Table 1 DCF Analysis Table 2 Variables Table 3 Regression Analysis Table 4 WACC Calculations Table 5 Payback Period Table 6 Depreciation Table 7 Call Option - NYSE Table 8 Call Option - S&P 500 Table 9 Put Option - NYSE Table 10 Put Option - S&P 500 Table 11 Sell A Call - NYSE Table 12 Sell A Call - S&P 500 Table 13 Sell A Put - NYSE Table 14 Sell A Put - S&P 500 Table 15 Covered Call - NYSE Table 16 Covered Call - S&P 500 Table 17 Protective Put - NYSE Table 18 Protective Put - S&P 500 Table 19 Protective Collar - NYSE Table 20 Protective Collar - S&P 500 Table 21 Long Straddle - NYSE Table 22 Long Straddle - S&P 500 Table 23 Short Straddle - NYSE Table 24 Short Straddle - S&P 500                
  • 4. Table of ExhibitsList of exhibits   @ RISK Sensitivity analysis  Exhibit A Change in Stock Price - NYSEExhibit B Payback Period - NYSEExhibit C Change in Stock Price – S&P 500Exhibit D Payback Period – S&P 500Exhibit E Call Option - 2034Exhibit F Put Option - 2034Exhibit G Long straddle - 2034Exhibit H Short straddle - 2034Exhibit I Input ResultsExhibit J Output ResultsExhibit K Detailed StatisticsExhibit L Sensitivity AnalysisExhibit M Scenario AnalysisExhibit N Model InputsExhibit O Model Outputs                          
  • 5. EVOLUTION OF PROJECT BOEING 7E7Boeing has always been a giant in the Aircraft manufacturing industry having Airbus as its onlyequal competitor. Boeing’s 737 have been considered to be one of the most successful ranges ofcommercial jets produced. Boeing 777 was considered to be a success when it was launched in1994 and from then it has not come up with a new commercial jet. It had announced andcancelled various projects like the Sonic Cruiser which promised up to 20% faster travel. Yetagain it failed to get recognition for its approval. In early 2003 Boeing announced the plans todesign and sell a new “super-efficient” jet called 7E7.The Market however was in a really bad shape due to various factors like Global terrorism, Iraqwar, Bio war resulting in intense travel situation. The leader of 7E7 project, Michael Blairdeclared that Boeing was making excellent progress on the development of 7E7 and arenegotiating terms with the authorities who need planes. Blair also announced the approval fromboard of Directors for the new planes design and development and the planes would be in servicefrom 2008. If, Boeing did not come with a new development in product then it was sure to loseits commercial aircraft sales to its chief rival company, Airbus, and face the financial crisis.7E7, also called, “Dreamliner”, would be capable of carrying 200-250 passengers for both short,domestic flights as well as the long, international flights. The aircraft was expected to consume20% less fuel and to be 10% cheaper than A330-200. Dreamliner was the first aircraft to usecarbon-reinforced composite material which would be stronger and lighter than theconventionally used aluminum. However, composite materials were considered the cause of theplane crash in 2001, so Boeing will have to prove the sustainability of composite materials. Also,Boeing will have to change the production method radically if it had to use composites, whichwould increase the cost of production.Nevertheless, Boeing promised that use of composites would reduce manufacturing cost and alsothe plane would be fuel efficient. To make the aircraft capable of flying both short haul and longhaul distances different wingspans for the aircrafts will be required. Engineers considered usingSnap-On wing extension. However, cost and technical feasibility was a concern for the Snap-Onwing extension consideration.    
  • 6. The cost of 7E7 project development would be $10 billion approximately but the board ofdirectors wanted to keep the cost down to 40% of what it took to develop the 777. The board alsowanted to keep the per-copy costs to 60% of the 777 costs. Looking at all the pros and cons,Boeing’s CEO said that it was their responsibility to develop jetliners for less and that if Boeingdidn’t take the risk in the commercial aircraft industry then it might affect their sustainability inthe market as their competitor Airbus was gaining control over the market. Airbus received 233commercial orders as compared to Boeing’s 176 orders, representing a 57% unit market shareand an estimated 53.5% dollar value market share.Primarily, Boeing had commercial airplanes and integrated defense systems segments. Revenuesfor defense system were rising whereas there was a loss of revenue in commercial airplanesegment. The revenues from commercial aircrafts were estimated to be $22 billion in 2003,lesser than $28 billion revenues in 2002. The commercial aircraft demand was dropped due toSeptember 11 attacks and hence the company reduce the production rates to half to maintain theprofitability in that segment. Boeing’s earnings had drop significantly from $2,827 million in2001 to $492 million in 2002 because of the accounting change. The drop in commercial aircraftdeliveries from 527 in 2001 to 381 in 2002 also accorded for the loss of revenues.Boeing’s market outlook in the short term air travel is influenced by business cycles, consumerconfidence and exogenous events but in the next 20 year the economies will grow by 3.2%annually and air travel will grow at an average annual rate of 5.1%. Boeing forecasted 24,276new commercial aircraft over 20 year period from 2003 to 2022 which was valued at 1.9 trillionin 2002.The development of new airframe meant huge initial cash outflows which should be gained backin a decade or two. These financial constraints indicate that each aircraft was a risky propositionkeeping in mind the rigorous competition in the market. To survive in the industry, company willhave to introduce successful products and sound financial position to survive the initial cashoutflows.The concept of B7E7 was derived from customer requirements and so was based on lowoperating cost. 7E7 was considered with two models: Basic and stretch. It had wider aisles,lower cabin altitude, increased cabin humidity, in-flight entertainment, internet access, and real-    
  • 7. time airplane system and structures health monitoring and crew connectivity for better customersatisfaction. Boeing claimed it to be the quietest aircraft in terms of takeoff and landing. Boeingprojected the demand of 2000 to 3000 aircrafts of 7E7 type in the next 20 years. However, thedemand was dependent on whether Boeing will be able to deliver the promise of fuel efficiencyand range flexibility.Boeing faced the uncertainty of being able to deliver all the promises that I made. Also, it had therisk of demand if Airbus duplicated it design. Boeing forecasted its IRR to be 16%. Interpolatingbetween 777 and 767, it was possible for Boeing to estimate value and using this methodcompany estimated minimum price of $114.5 million 7E7 basic model and $144.5 million for7E7 stretch model. The forecast assumed $8 billion for development cost but the board ofdirectors was anxious to reduce those costs. The engineering design could push up the costssignificantly whereas; if Boeing succeeded in using composite materials then the constructioncost would reduce. The IRR of 7E7 was very sensitive to keeping production costs low. Themagnitude of risk posed by launching of a major new aircraft was accepted as a matter of course.Michael Bair said that they can’t let what’s happening today cause them to make bad decisionsfor this long business cycle and that 7E7 was very important for their future.                        
  • 8. Empirical Data used for Boeing 7E7 case analysis (refer Table 02)Number of 7E7 planes delivered from year 1-20 = 2500Number of 7E7 planes delivered from year 21-30 = 115Initial Price of 7E7 plane as per 2008 = $135.4 millionInitial Price of 7E7 stretch planes as per 2010 = $177.7 millionCost of Goods Sold (% Sales) = 80%Working Capital (% Sales) = 6.70%GS&A expenses (% Sales) = 7.50%Inflation = 2%Depreciation = 150%Terminal value -Project is of limited duration = 0R&D Expenses (% Sales) -excluding 2004 to 2007 = 2.30%Capital expenditure (% Sales) -excluding 2004 to 2007 = 0.16%Initial Development Costs -2004 to 2009 = $8,000.00 Year 2004 2005 2006 2007 2008 2009Development Costs 2004 – 5% 15% 50% 15% 10% 5%2009 (% of Initialdevelopment cost)R&D Expenses for 2004 - 2009 (% Development Costs) = 75%Capital expenditure 2004 - 2009 (% Development Costs) = 25%Internal rate of return = 15.79%          
  • 9. On analyzing the 7E7 project Case and the financial data given in Exhibit 1 thru Exhibit 11 ofthe Darden Business Publishing Document UVA-F-1449, the following variables and theirvalues are calculated for the purpose of discounted cash flow analysis. – Refer Table 02Revenue – The revenues of the company are generated from the sale of the following airplanes: a) 7E7 Planes b) 7E7 Stretch PlanesThe initial price of a 7E7 in year 2002 is estimated to be $120.2 million after considering theadditional 5% premium paid by customers.The initial price of a 7E7 Stretch in year 2002 is estimated to be $151.7 million after consideringthe additional 5% premium paid by customers.The revenues grow annually by the inflation rate of 2%. The analysis assumes a total of 3650planes (2500- 7E7 & 1150 – 7E7 Stretch) to be produced over the period of the 7E7 project.Expenses – The main expenses in this project are assumed to be the Cost of Goods sold, theGS&A expenses, Depreciation, Research and Development expenses and the Tax expense.The Cost of Goods Sold expense is estimated to be 80% of the Revenues generated every year.The General, Selling and Administrative Expenses are assumed to be 7.5% of the Revenuesgenerated every year.Depreciation - Cash flow analysis is performed using the accelerated depreciation method. Inthis project we forecast using 150% declining balance depreciation with a 20 year asset life andzero salvage value as the base. The cost is considered here as the Capital Expenditure. ReferTable 06.Research and Development (R&D) expenses – The R&D expenses from 2008 is assumed to be2.30% every year. In the initial years of development, the R& D expenses are high, accounting toalmost 75% of the development costs for the period. (2002-2009)The development costs are spread over a period of six years with a total budget of $ 8 Billion(Refer Table 02).    
  • 10. Tax - The amount of tax to be paid is determined by accounting the tax rate to the taxableincome. Taxable Income = EBIT – Interest Taxes = Tax Rate * Taxable Income.The corporate tax rate used for analysing the 7E7 case is 35%.Capital Expenditure (Capex) – The capital expenditure for the initial period (2004-2007) isestimated to be 25% of the Development costs for the period. Once production starts, the Capexis estimated to be 0.16% of Revenues.EBIT-Earnings before Interest and Taxes are calculated by subtracting the Depreciation fromEBITDA. EBIT = EBITDA – DepreciationNet Working Capital – In order to forecast the Net Working Capital, we assume the NetWorking Capital to be 6.7 % of the Revenue generated or Sales.Change in Net Working Capital - The difference in Net working capital between twosuccessive years.Free Cash Flow – The free cash flow is calculated using the following formula: F.C.F = EBIT + Depreciation – Taxes – Capex – ΔNWCTerminal Value - It is the anticipated value of the FCF at a specified future valuation date. Inthis project, we assume the terminal value to be zero, since the project is of limited duration.In order to find the Net Present Value, the discount rate is estimated using the Weighted AverageCost of Capital method.    
  • 11. Weighted Average Cost of CapitalIn this analysis, we assume the capital structure of Boeing to compose of Equity and Debtthrough Bonds. Since the 7E7 is a commercial project, we need to assume the commercial shareof Boeing’s capital structure in the calculation of the WACC. WACC= (% Debt * Rd*(1-tc)) + (% Equity *Re) …. Equation 1Boeings Commercial Beta Calculations   Unlevered Beta Derivation +The value of a firm debt can be thought of as the sum of the market value of its debt (D andEquity (E) or the sum of its value as if unlevered (VUL) plus the benefit of the corporate debt taxshield.    
  • 12. The weighted average of the debt and equity betas should equal a weighted average of Beta.In the analysis, the following Beta-Levered values for 60 trading months from the NYSE andS&P Index are taken: Beta-­‐Levered   NYSE   S&P  500   Beta  (L)  -­‐Boeing   1   0.8   Beta  (L)  -­‐Lockheed   0.49   0.36   Beta  (L)  -­‐Northrop   0.44   0.34  The Beta unlevered value of the Boeing Asset can be found using the below formula:     ⎛      (    -   t  c   )D   ⎞     1       β  L   =   ⎜1  +     ⎟  β  U   …….    (Equation 2)   ⎝   E   ⎠  Assumptions:Corporate Tax Rate (tc) = 35%D/E (Boeing) = 0.525The Debt capital structure is about 65.66% of the Total capital structure and the Equity capitalstructure is about 34.34% of the Total capital structure. The weights are divided based on theDebt/ Equity Ratio of 52.50 %.The Beta Unlevered value for the Boeing Asset is 0.746 (NYSE) and 0.525 (S&P 500).Being’s Defense BetaIn order to find Beta-Defense of Boeing, we first need to find the unlevered Beta values ofLockheed and Northrop Grumman and then average out the values of Beta-Defense of Lockheedand Beta-Defense of Northrop Grumman to estimate a Beta-Defense value for Boeing.Note: Since Lockheed Martin and Northrop Grumman specialize in Defense, the betas of thesetwo companies closely represent the Beta-Defense of Boeing and this is used in the calculationof WACC.    
  • 13. Assumptions:D/E-Lockheed =0.41D/E-Northrop Grumman- 0.64The unlevered Beta values for Lockheed is 0.387(NYSE) and 0.255 (S&P 500).The unlevered Beta values for Northrop Grumman is 0.311(NYSE) and 0.207 (S&P 500).On averaging out the Beta values of Lockheed and Northrop Grumman we estimate the Beta-Defense of Boeing to be 0.349 (NYSE) and 0.231 (S&P 500)Beta- Unlevered of Boeing = (Beta-Commercial * Share of Commercial) + (Beta-Defense *Share of Defense) ……. (Equation 3)Assumptions: Based on the revenue figures, the commercial share is assumed to be 54% and thedefense share is 46%.On substitution in the above formula, we get the Unlevered value for Beta-Commercial to be1.084 (NYSE) and 0.774 (S&P 500).To find the levered –Beta value for Boeing- Commercial, re-lever using Equation 2.The commercial Beta –Levered value is 1.453 (NYSE) and 1.181 (S&P 500)Cost of Equity commercial    +       commercial   r   equity   r  =       f   β equity   *   (r     m   r     )        -     f      ……. (Equation  4)  The return on equity is calculated using the above equation. Using the below assumed values andthe derived values of Commercial Beta, the cost of commercial equity is derived.The analysis assumes a risk free rate (Rf) of 4.56 % keeping in account the long-term effect ofthe market conditions on the Boeing 7E7 project.    
  • 14. Assumptions:Risk Free Rate (Rf) 4.56%Risk Premium 8%The cost of equity is 16.19 % (NYSE) and 14.01 % (S&P 500)Cost of DebtIn this analysis, the cost of debt is calculated using Regression Analysis, in order to achieve aYield to Maturity (YTM) value that is representative of the total outstanding bonds in thecompany (Refer Table 04).Using Regression Analysis (Refer Table 04), the cost of debt (Rd) is 5.54%Calculation of WACCSubstituting the below assumed values and derived values of Re and Rd in Equation 1.Assumptions:E/(E+D) 0.656D/(E+D) 0.344WACC (NYSE) = 12.52% and WACC (S&P 500) = 10.43% WACC CALCULATION NYSE S&P 500 Beta unlevered (Boeing) 0.746 0.525 Beta unlevered (Lockheed) 0.387 0.255 Beta unlevered (Northrop) 0.311 0.207 Beta unlevered (Boeing-Defense) 0.349 0.231 Total Defense 0.160 0.106 Total Commercial 0.585 0.418 Commercial Beta unlevered 1.084 0.774 Commercial Beta levered 1.453 1.181 Cost of Equity 16.19% 14.01% WACC 12.52% 10.43%    
  • 15.  The Net present value of all the Cash flows is equal to Present Value of all Cash Flows from2004 to 2037.We get a Net Present Value = Zero when the Internal Return Rate of 15.79% is used todiscount the free cash flows using the following formula: PV=Annual Free Cash Flow / [(1+IRR/WACC (NYSE or S&P 500) ^Time period]. Net Present Value = PV of all Future cash flows in the period (2004-2037)The Net Present value using the Weighted Average Cost of Capital (NYSE and S&P 500) is asfollows: NPV (WACC NYSE) = $1765.57 NPV (WACC S&P 500) = $3571.25Then finally the change in price / share is determined by dividing the Net Present Value (NYSEand S&P 500) by the Total number of shares (in millions) Price/Share = Δ Total Present Value/ No. of shares Change in stock Price (NYSE) = $2.22 Change in Stock Price (S&P 500) = $4.50Payback period is calculated from Present values obtained using WACC (NYSE and S&P 500).The first positive present value marks the payback period which implies the year in which theinvested money is recovered.The payback period considering WACC (NYSE) is 17 years and WACC(S&P 500) is 15years. Refer table 05.    
  • 16. Investing in Stock OptionsTo order to estimate the investment opportunities for potential investors, a few stock optionshave been considered in this analysis:The change in stock prices over the period of the project from 2004 thru 2037 have been derivedbased on the change in Present Values of Future Cash Flows of the 7E7 Project for the sameperiod. (Refer Table 7 thru 24)In this analysis, the strike price is assumed to be $36.41 (same as the stock price value for year2003) and the premium per share for all the options have been fixed at $5 per share for Boeing(including defense and commercial). Since we are considering changes in stock price due to the7E7 project alone, we take into account the commercial share of Boeings revenues and the networth of this project in relation to the Total Net worth of the company comprising of all projects.For this analysis, the expiration date of the option is not considered, as the purpose of theanalysis is to highlight the most profitable option available for the investors.The analysis shows that the Stock Price initially decreases (low Present Values) because of thehigh development and Research costs in the pre-production phase. The stock price significantlyincreases post 2008, once the revenues start getting generated and then gradually increases tillthe end of the program.Premium per share for options related to the 7E7 project:Premium Price (Project) = Premium (Boeing) * Commercial Share of Boeing * (Net PresentValue of Project / Total Value)NYSE Index:Premium (Boeing) = $5Commercial Share of Boeing = 54%Net Present Value of Project = $1765.57Total Value of Company = $12,571.81Premium Price (Project) = 5 * 0.54 * (1765.57 / 12571.81)Premium Price (Project) = $ 0.38    
  • 17. S&P 500 Index:Premium (Boeing) = $5Commercial Share of Boeing = 54%Net Present Value of Project = $3571.25Total Value of Company = $12,571.81Premium Price (Project) = 5 * 0.54 * (3571.25 / 12571.81)Premium Price (Project) = $ 0.77Buy Call or Long–call Option:Strike / Exercise Price =$36.41Pay-Off = Stock Price – Strike PriceProfit = Pay-off – Premium PaidRefer Table 07 & Table 08 and the corresponding figures.Expectation:As the stock price is expect
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