Professional Documents
Culture Documents
- Jayaraj Somarajan
- Ajay Gnanashekaran
- Shafrin Maredia
Table of Contents
Sl.No
1.
2.
3.
4.
5.
6.
7.
10.
11.
Contents
Evolution of Project Boeing 7E7
Empirical Data
7E7 Project NPV DCF Analysis
WACC Calculation
Payback Period
Stock Options
@ Risk Analysis
Conclusion
References
Page
1
4
5
7
11
12
22
23
24
Table of Tables
Table Number
Table 1
Table 2
Table 3
Table 4
Table 5
Table 6
Table 7
Table 8
Table 9
Table 10
Table 11
Table 12
Table 13
Table 14
Table 15
Table 16
Table 17
Table 18
Table 19
Table 20
Table 21
Table 22
Table 23
Table 24
Content
DCF Analysis
Variables
Regression Analysis
WACC Calculations
Payback Period
Depreciation
Call Option - NYSE
Call Option - S&P 500
Put Option - NYSE
Put Option - S&P 500
Sell A Call - NYSE
Sell A Call - S&P 500
Sell A Put - NYSE
Sell A Put - S&P 500
Covered Call - NYSE
Covered Call - S&P 500
Protective Put - NYSE
Protective Put - S&P 500
Protective Collar - NYSE
Protective Collar - S&P 500
Long Straddle - NYSE
Long Straddle - S&P 500
Short Straddle - NYSE
Short Straddle - S&P 500
Table of Exhibits
List of exhibits
Exhibit A
Exhibit B
Exhibit C
Exhibit D
Exhibit E
Exhibit F
Exhibit G
Exhibit H
Exhibit I
Exhibit J
Exhibit K
Exhibit L
Exhibit M
Exhibit N
Exhibit O
The cost of 7E7 project development would be $10 billion approximately but the board of
directors wanted to keep the cost down to 40% of what it took to develop the 777. The board also
wanted to keep the per-copy costs to 60% of the 777 costs. Looking at all the pros and cons,
Boeings CEO said that it was their responsibility to develop jetliners for less and that if Boeing
didnt take the risk in the commercial aircraft industry then it might affect their sustainability in
the market as their competitor Airbus was gaining control over the market. Airbus received 233
commercial orders as compared to Boeings 176 orders, representing a 57% unit market share
and an estimated 53.5% dollar value market share.
Primarily, Boeing had commercial airplanes and integrated defense systems segments. Revenues
for defense system were rising whereas there was a loss of revenue in commercial airplane
segment. 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 to
September 11 attacks and hence the company reduce the production rates to half to maintain the
profitability in that segment. Boeings earnings had drop significantly from $2,827 million in
2001 to $492 million in 2002 because of the accounting change. The drop in commercial aircraft
deliveries from 527 in 2001 to 381 in 2002 also accorded for the loss of revenues.
Boeings market outlook in the short term air travel is influenced by business cycles, consumer
confidence 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 24,276
new commercial aircraft over 20 year period from 2003 to 2022 which was valued at 1.9 trillion
in 2002.
The development of new airframe meant huge initial cash outflows which should be gained back
in a decade or two. These financial constraints indicate that each aircraft was a risky proposition
keeping in mind the rigorous competition in the market. To survive in the industry, company will
have to introduce successful products and sound financial position to survive the initial cash
outflows.
The concept of B7E7 was derived from customer requirements and so was based on low
operating 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
time airplane system and structures health monitoring and crew connectivity for better customer
satisfaction. Boeing claimed it to be the quietest aircraft in terms of takeoff and landing. Boeing
projected the demand of 2000 to 3000 aircrafts of 7E7 type in the next 20 years. However, the
demand was dependent on whether Boeing will be able to deliver the promise of fuel efficiency
and range flexibility.
Boeing faced the uncertainty of being able to deliver all the promises that I made. Also, it had the
risk of demand if Airbus duplicated it design. Boeing forecasted its IRR to be 16%. Interpolating
between 777 and 767, it was possible for Boeing to estimate value and using this method
company estimated minimum price of $114.5 million 7E7 basic model and $144.5 million for
7E7 stretch model. The forecast assumed $8 billion for development cost but the board of
directors was anxious to reduce those costs. The engineering design could push up the costs
significantly whereas; if Boeing succeeded in using composite materials then the construction
cost would reduce. The IRR of 7E7 was very sensitive to keeping production costs low. The
magnitude of risk posed by launching of a major new aircraft was accepted as a matter of course.
Michael Bair said that they cant let whats happening today cause them to make bad decisions
for this long business cycle and that 7E7 was very important for their future.
Empirical Data used for Boeing 7E7 case analysis (refer Table 02)
Number of 7E7 planes delivered from year 1-20 = 2500
Number of 7E7 planes delivered from year 21-30 = 115
Initial Price of 7E7 plane as per 2008 = $135.4 million
Initial Price of 7E7 stretch planes as per 2010 = $177.7 million
Cost 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 = 0
R&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
Development Costs 2004
2009 (% of Initial
development cost)
2004 2005
5% 15%
2006
50%
2007
15%
2008
10%
2009
5%
On analyzing the 7E7 project Case and the financial data given in Exhibit 1 thru Exhibit 11 of
the Darden Business Publishing Document UVA-F-1449, the following variables and their
values are calculated for the purpose of discounted cash flow analysis. Refer Table 02
Revenue The revenues of the company are generated from the sale of the following airplanes:
a) 7E7 Planes
b) 7E7 Stretch Planes
The initial price of a 7E7 in year 2002 is estimated to be $120.2 million after considering the
additional 5% premium paid by customers.
The initial price of a 7E7 Stretch in year 2002 is estimated to be $151.7 million after considering
the additional 5% premium paid by customers.
The revenues grow annually by the inflation rate of 2%. The analysis assumes a total of 3650
planes (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, the
GS&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 Revenues
generated every year.
Depreciation - Cash flow analysis is performed using the accelerated depreciation method. In
this project we forecast using 150% declining balance depreciation with a 20 year asset life and
zero salvage value as the base. The cost is considered here as the Capital Expenditure. Refer
Table 06.
Research and Development (R&D) expenses The R&D expenses from 2008 is assumed to be
2.30% every year. In the initial years of development, the R& D expenses are high, accounting to
almost 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).
Tax - The amount of tax to be paid is determined by accounting the tax rate to the taxable
income.
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) is
estimated to be 25% of the Development costs for the period. Once production starts, the Capex
is estimated to be 0.16% of Revenues.
EBIT-Earnings before Interest and Taxes are calculated by subtracting the Depreciation from
EBITDA.
EBIT = EBITDA Depreciation
Net Working Capital In order to forecast the Net Working Capital, we assume the Net
Working Capital to be 6.7 % of the Revenue generated or Sales.
Change in Net Working Capital - The difference in Net working capital between two
successive years.
Free Cash Flow The free cash flow is calculated using the following formula:
F.C.F = EBIT + Depreciation Taxes Capex NWC
Terminal Value - It is the anticipated value of the FCF at a specified future valuation date. In
this 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 Average
Cost of Capital method.
. Equation 1
+
The value of a firm debt can be thought of as the sum of the market value of its debt (D and
Equity (E) or the sum of its value as if unlevered (VUL) plus the benefit of the corporate debt tax
shield.
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 and
S&P Index are taken:
Beta-Levered
Beta
(L)
-Boeing
Beta
(L)
-Lockheed
Beta
(L)
-Northrop
NYSE
1
0.49
0.44
S&P
500
0.8
0.36
0.34
The Beta unlevered value of the Boeing Asset can be found using the below formula:
(1
-
t
c
)D
L
=
1
+
U
E
. (Equation 2)
Assumptions:
Corporate Tax Rate (tc) = 35%
D/E (Boeing) = 0.525
The Debt capital structure is about 65.66% of the Total capital structure and the Equity capital
structure is about 34.34% of the Total capital structure. The weights are divided based on the
Debt/ Equity Ratio of 52.50 %.
The Beta Unlevered value for the Boeing Asset is 0.746 (NYSE) and 0.525 (S&P 500).
Beings Defense Beta
In order to find Beta-Defense of Boeing, we first need to find the unlevered Beta values of
Lockheed and Northrop Grumman and then average out the values of Beta-Defense of Lockheed
and 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 these
two companies closely represent the Beta-Defense of Boeing and this is used in the calculation
of WACC.
Assumptions:
D/E-Lockheed =0.41
D/E-Northrop Grumman- 0.64
The 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 BetaDefense 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 the
defense share is 46%.
On substitution in the above formula, we get the Unlevered value for Beta-Commercial to be
1.084 (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
equity
+
commercial
equity
(r
r )
. (Equation
4)
The return on equity is calculated using the above equation. Using the below assumed values and
the 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 of
the market conditions on the Boeing 7E7 project.
Assumptions:
Risk Free Rate (Rf)
4.56%
Risk Premium
8%
0.656
D/(E+D)
0.344
WACC CALCULATION
NYSE
S&P 500
0.746
0.525
0.387
0.255
0.311
0.207
0.349
0.231
Total Defense
0.160
0.106
Total Commercial
0.585
0.418
1.084
0.774
1.453
1.181
Cost of Equity
16.19%
14.01%
WACC
12.52%
10.43%
The Net present value of all the Cash flows is equal to Present Value of all Cash Flows from
2004 to 2037.
We get a Net Present Value = Zero when the Internal Return Rate of 15.79% is used to
discount 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 as
follows:
NPV (WACC NYSE) = $1765.57
NPV (WACC S&P 500) = $3571.25
Then finally the change in price / share is determined by dividing the Net Present Value (NYSE
and S&P 500) by the Total number of shares (in millions)
NYSE Index:
Premium (Boeing) = $5
Commercial Share of Boeing = 54%
Net Present Value of Project = $1765.57
Total Value of Company = $12,571.81
Premium Price (Project) = 5 * 0.54 * (1765.57 / 12571.81)
Premium Price (Project) = $ 0.38
Maximum Gain:
The pay-off increases continuously; the profit potential is high. In the last year of the project, the
pay-off for buying a call option for the project reaches a maximum of $ 2.22 per share (NYSE)
and $4.50 per share. (S&P 500)
Expectation:
As the stock price is expected to rise continuously, this strategy is considered somewhat
unsuitable once the production starts and starts making revenues. It is considered a bad option
barring the initial years as depicted by the pay-off curve.
Maximum Loss:
The maximum loss is limited. It is incurred when the stock price is above the exercise / strike
price. Once production starts, the revenues are generated and the company will start reducing the
losses and will starting making profits, the option holders will face losses with a maximum loss
in the option equal to the premium paid i.e., $ 0.38 for NYSE and $ 0.77 for S&P 500.
Maximum Gain:
The initial years of the project have huge expenses and with the put option, the option holders
will get profits. The pay-off decreases continuously; the profit potential is low. In the last few
years of the project, the pay-off for buying a put option for the project reaches a min of $ -0.38
per share (NYSE) and $-0.77 per share (S&P 500).
Expectation:
The stock price is expected to be steady or slight rise. The option is not appropriate for a very
bearish or very bullish investor.
Maximum Loss:
Theoretically the loss is limited, but is very substantial. The worst that can happen is for the
stock to fall to zero, in which case the seller would buy the stocks at the strike price and sell it to
the holder. The loss would be partially offset by the premium received. In this case, the
minimum pay-off expected is $-2.90 (NYSE) and $-3.01 (S&P 500).
Maximum Gain:
The maximum gains on the strategy are very limited. The total net gains depend in part on the
call's intrinsic value when sold, and on prior unrealized stock gains or losses. In this case, the
maximum profit is $ 0.38 (NYSE) and $ 0.77 (S&P 500)
@RISK ANALYSIS
The project was evaluated using the @Risk software to find the various possibilities of
outputs in the given case scenario with varying inputs. For the purpose of this project, the
following were taken to be in the varying inputs for the analysis:
The most affecting factor for Stock price change was Initial Development costs, while the
same for Option profits was Cost of Goods Sold.
There is almost 100% probability that the stock prices will have a higher value after to
the implementation of the project.
There is almost 95% probability that the invested amount can be recovered within 22 and
17 years when considering the NYSE and S&P 500 indices respectively.
Almost 100% probability of profits in Call options and 95% probability of losses in Put
options show that the stock prices are expected to rise in the given scenario.
Similarly, Almost 100% probability of profits in Long Straddle and 100% probability of
losses in Short straddle show that the money invested will provide a profit only in long
term.
Conclusion
As per the analysis, it is found that the Net present value of the 7E7, with the WACC from
NYSE index and the S&P 500 index is positive. The Company should expect to get a return on
the money invested by recovering the high initial research and development expenses in the 17th
year as per the NYSE index and in the 15th year as per the S&P 500 index.
As per our recommendation, based on the analysis of the case and other financials, if the board
of The Boeing Co. invests in the 7E7 project then the project would significantly increase the
stock price of the company and would be very beneficial in the long run, giving an edge over its
competitors, especially Airbus.
References
Bruner, R., & Tompkins, J. (2004). The Boeing 7E7. Informally published manuscript, Darden
School of Business, University of Virginia, Charlottesville, VA , , Available from Darden
Business Publishing. Retrieved from https://store.darden.virginia.edu/business-casestudy/the-boeing-7e7-657
Options Industry Council. (n.d.). Strategies. Retrieved from
http://www.optionseducation.org/strategies_advanced_concepts/strategies.html