BUSA 4800: Airbus Case Study

Boeing Perspective

BUSA A
Goal

To maximize profits and minimize risk by keeping our costs low and using our brand.

Estimated Figures
Demand
In an attempt to predict future demand, we need to look at past behavior, according to

Voyle (1996) “past behavior is the best predictor of future behavior” (p.49). When attempting to

predict future demand, we must look at the trend over the past 20 years to establish what the

demand could be for the next 20 years. We began by examining the percentage change over the

past 20 years and discovered that, from 1980-2000, demand had increased by thirty percent. In

light of that discovery, we expect demand will continue to increase by that percentage over the

next twenty years. To examine that we multiplied the total market number of aircraft orders for

this

year,

518

aircrafts, and multiplied them by 1.30 to give us the forecasted demand in twenty years which

was 1412 aircrafts.

Cost of Capital
In determining Boeing’s Cost of Capital, we first utilized the CAPM method to determine

the required return for shareholders. Our risk free variable was taken from the long-term U.S.

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government bond rate which was approximately 6.0%. The asset beta for aircraft manufacturers

like Boeing and Bombardier was 0.84. The Rm variable we entered as 15% as this was a

conservative expectation for the pretax IRR. Upon plugging these variables into the CAPM

formula we came out with a required return of 13.56%. Given that Boeing has both Debt and

Equity, we could not stop there; we had to find the Weighted Average Cost of Capital.

Upon examining Boeing’s financial statement, we discovered that of their capital 84.14%

was shareholder equity and 15.86% was debt. Given that Boeing is a U.S. based company, they

are obligated to pay the U.S. Corporate Tax Rate. According to Fiscal Facts 2010, the U.S.

corporate tax rate in 2000 was 39.4%.

For Re, we utilized the required return of 13.65% which we established from Ke in the

CAPM model. Keeping the same Rd of 6%, we plug all the variables into the formula and

discover that Boeings cost of capital is 11.99%.

Growth Rate and Boeing’s Capital Investments

To match our management’s preference of being conservative and risk adverse, the rate

of growth for the terminal value, or salvage value, of the A3XX project reflects only the

projected inflation. We took the consumer price index (CPI) data for the last ten years and

extrapolated a value for future inflation based on the average. The figure came out to 3.05%.

When considering Boeing’s capital investments, it is important to note that, henceforth,

when we refer to Boeing “launching” a product it will be an expanded or stretched version of the

current 747 aircraft – NOT an entirely new aircraft. With that in mind, in-house projections

within Boeing believe it will cost $7 billion to redesign the 747 aircraft into a 747-stretch. It is

estimated that $5 billion will be needed for research and development and $2 billion for capital

expenditures.

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Key Success Factors
Boeing focuses on building aircraft carriers and factors that have made them successful

have been their brand itself as well as their ability to reduce their costs. Boeing began building

747 aircrafts in 1967, at this point Airbus did not have an aircraft in the Very Large Aircraft

(VLA) market that could compete with Boeing’s 747 which gave them a large advantage in

terms of brand recognition within that market. Since Boeing already had more than twenty

successful years of experience with building VLAs more companies would be inclined to

purchase a Boeing aircraft. As a result of their brand recognition, Boeing has maintained

importance with the US government by being one of its largest defense contractors through their

supply of military aircraft and missiles, which accounts for one-third of Boeing’s revenues.

This has also put them in a monopolistic position in the VLA market.

Boeing’s other success factor is their ability to reduce their costs. Through their own

learning curve, developed through experience with earlier models of the 747 as well as customer

demand, Boeing has been able to forecast when to cut costs in order to maintain profitability. By

merely utilizing simpler methods to configure and produce their aircrafts they would reduce

costs associated with plane production which would ultimately reduce the price of each plane. As

a result of these two factors, Boeing has been able to maintain an industry leading position.

Management Preferences
The cost to launch the original Boeing 747, in 1967, was predicted to be $1.5 billion,

however this estimate was largely underestimated and as a result Boeing required 30 years to

recover from costs associated with creating the 747. Since two thirds of Boeing’s revenues came

from sales of commercial aircraft, it is likely Boeing recovered most of their 747 financial loss

from sales of products related to military and government contracts. An important point to add,

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during the launch of the original 747, Boeing was charged penalties for late deliveries related to

the 747 and these delays lead to stalls in revenue because buyers did not wish to pay a troubled

Boeing until a finished plane was in possession. Taking these points into consideration, Boeing

management should exercise caution when deciding to create a newly designed large plane.

Even though introducing a stretch 747 would likely increase share value in the short run,

the risk associated with a troubled launch of the stretched 747 could send Boeing back to fear

bankruptcy. Another negative factor associated with a troubled launch would be the potential of

share values drastically falling if such a situation occurred.

Industry Environment Factors

One threat to predict demand for newly designed large aircrafts is the life span of a

Boeing 747. Its life span is predicted to be 30 years, however, some industry observers estimate

it may exceed 50 years. This long product life can reduce the likelihood of Boeing’s repeat 747

purchases as some companies may maintain their old 747s to avoid heavy investments in new

large aircrafts that could cost between $510 million (747 jet) to $216 million (A3XX jet) per

plane compared to performing maintenance on a single part of a plane.

Another threat to predict demand of large aircrafts is fragmentation and the use of point-

to-point flight operations versus spoke-and-hub operations. Large aircrafts, like a 747 for

example, use spoke-and-hub, while smaller to medium jets use point-to-point. Smaller aircrafts

with long-range operation from point-to-point are substitute products for large aircrafts like the

747 and even the Airbus A3XX. Therefore, demand for large aircrafts are threatened by demand

for small to medium jets using point-to-point operations. United, American Airlines, Delta

Airlines, Southwest Airlines, Buzz, and easyJet have all depicted examples of successful point-

to-point operations.

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Finances
The main financial factors taken into consideration to measure Boeing’s status

performance are their assets, source of cash, debt, and profitability. Boeing currently has $15.71

billion in current assets and $36.15 billion in total assets which are derived mainly by customer

and commercial financing, property, plant and equipment, goodwill and acquired intangibles,

prepaid pension expense, and deferred income taxes.

In terms of cash, their sales figures have shown a consistent increase since 1995,

increasing to $57.99 billion dollars in 1999. Additionally, Boeing currently has $3.35 billion in

cash and cash equivalents. Unfortunately this is not nearly enough for Boeing to launch a $7

billion project should they choose to develop and launch a new aircraft, without considering

$6.73 billion of total debt they also have.

Boeings short-term debt accounts for $752 million dollars while their long term debt

accounts for $5.98 billion. Paying off short term debt is very important to Boeing as it funds their

regular operations. If these dues are not paid off they may be faced with default which would

negatively affect the company and its shareholders.

Lastly, during the past five years, the firm has demonstrated their lucrative ability. But

within this period of time, it is evident that they have only been profitable for three of those five

years, having lost money in 1995 and 1997. Although Boeing has experienced increases in net

income of $1.2 billion from 1998 to $2.3 billion presently, it seems as if they are venerable to

fluctuations and their future in terms of financial performance is unpredictable.

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Recommendation: No Launch
It is our recommendation that Boeing does not launch a new product. Although the

payoff model we have, shows that launching offers a greater payoff, manipulation of interest

rates and demand show that small changes result in dramatic alterations in the NPV in a launch

scenario. A no launch decision is also conducive to our management preference of conservatism

and risk aversion. Finally, we believe that launching a new product will also ignore the key

factors that make our company successful.

Given the dangers we experienced with the development of the 747 as discussed in the

management preferences section, we must be extra careful not to gamble with our entire

company yet again by launching a new product. The fact that we had profits in only three of the

last five years is extremely troubling and definitely reinforces our company’s preference for risk

aversion. Moreover, since we are already leveraged and lack the cash reserves to completely

fund a new product we would have to finance through debt.

Although, our payoff model shows that maximum payoff is obtained through launching a

new product, interest rate analysis, as demonstrated in Appendix 1, shows that launch scenario is

extremely vulnerable to changes in interest rates. A small increase of just 1.58% interest will

diminish NPV in the launch scenario to the same levels in the no launch scenario. By not

launching a new product, Boeing does not have to take on additional debt. Our financial analysis

above demonstrates that although we have cash, it comes nowhere close to being able to finance

an endeavor like the 747 stretch. Debt financing will have to occur which explains the increased

exposure to interest rate changes. Likewise, if demand decreases by 17%, NPV for launch will

again drop to the same levels to that of the no launch scenario. We must also take into account

the risk of cost over runs. There is no risk if we do not launch. However, this risk is very

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evident in the launch scenario. Cost over runs can result in lower NPV even if interest rates and

demand stay the same.

Finally, launching a new product goes against two factors that make Boeing successful.

We have been building the 747-400 for twenty years and the learning curve has allowed us to cut

costs. The launch of a new product will eliminate these cuts and we will have to start at the very

bottom of the learning curve yet again. Uncertainty in branding will also adversely affect the

company. The 747 has been on the market for twenty years and its costs, benefits, etc. are

known and quantifiable. Businesses looking to purchase new aircraft can make better strategic

decisions when they purchase the 747.

Implementation
For Boeing we recommend the following tactics:

 We do not recommend a launch of a stretch 747. In five years, we recommend Boeing

increase the selling price of their 747s in small increments. As market share shifts

towards Airbus, Boeing will need to maintain optimal profits by raising prices as

displayed in our cash flow model.

 Monitor interest rates and demand for Boeing 747s. Industry conditions may change and

a good opportunity to launch may present itself in the future.

 Reconsider launching the stretched 747 or a new super jumbo jet in the future.

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Appendix
NOTE: NPV in millions

Boeing interest: 11.99%

demand: 1412.23
L NL
linked demand to calculation 1412.23
$ 7,028.15 $ 6,389.76 linked to WACC 11.99%

L $ 5,777.71 $ 7,411.78

Airbus NL_NPV - L_NPV: $ (638.39)

$ 12,858.62 $ 11,742.84

NL $ - $ -

Figure 1: Current Interest Rate and Demand

NOTE: NPV in millions

Boeing interest: 13.57%

demand: 1412.23
L NL
linked demand to calculation 1412.23
$ 5,554.91 $ 5,557.17 linked to WACC 11.99%

L $ 5,777.71 $ 7,411.78

Airbus NL_NPV - L_NPV: $ 2.27

$ 10,270.18 $ 9,886.36

NL $ - $ -

Figure 2: Interest Rate Increase 1.58%

NOTE: NPV in millions

Boeing interest: 10.41%

demand: 1412.23
L NL
linked demand to calculation 1412.23
$ 9,138.03 $ 7,543.72 linked to WACC 11.99%

L $ 5,777.71 $ 7,411.78

Airbus NL_NPV - L_NPV: $ (1,594.31)

$ 16,561.03 $ 14,358.93

NL $ - $ -

Figure 3: Interest Rate Decrease 1.58

NOTE: NPV in millions

Boeing interest: 11.99%

demand: 1172.1509
L NL
linked demand to calculation 1412.23
$ 5,708.91 $ 5,735.45 linked to WACC 11.99%

L $ 3,178.33 $ 4,501.78

Airbus NL_NPV - L_NPV: $ 26.55

$ 10,548.20 $ 10,178.51

NL $ - $ -

Figure 4: Demand Decrease 17%

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NOTE: NPV in millions

Boeing interest: 11.99%

demand: 1652.3091
L NL
linked demand to calculation 1412.23
$ 8,347.38 $ 7,044.06 linked to WACC 11.99%

L $ 8,431.02 $ 10,379.78

Airbus NL_NPV - L_NPV: $ (1,303.33)

$ 15,169.04 $ 13,307.16

NL $ - $ -

Figure 5: Demand Increase 17%

NOTE: NPV in millions

Boeing interest: 14.99%

demand: 1412.23
L NL
linked demand to calculation 1412.23
$ 4,569.82 $ 4,981.56 linked to WACC 11.99%

L $ 5,777.71 $ 7,411.78

Airbus NL_NPV - L_NPV: $ 411.74

$ 8,536.85 $ 8,623.77

NL $ - $ -

Figure 6: Interest Increase 3%

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NOTE: NPV in millions

Boeing interest: 8.99%

demand: 1412.23
L NL
linked demand to calculation 1412.23
$ 11,984.55 $ 9,057.22 linked to WACC 11.99%

L $ 5,777.71 $ 7,411.78

Airbus NL_NPV - L_NPV: $ (2,927.33)

$ 21,551.64 $ 17,840.97

NL $ - $ -

Figure 7: Interest Decrease 3%

NOTE: NPV in millions

Boeing interest: 11.99%

demand: 1059.1725
L NL
linked demand to calculation 1412.23
$ 5,088.09 $ 5,427.55 linked to WACC 11.99%

L $ 1,977.83 $ 3,156.83

Airbus NL_NPV - L_NPV: $ 339.46

$ 9,460.95 $ 9,442.36

NL $ - $ -

Figure 8: Demand Decrease 25%

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NOTE: NPV in millions

Boeing interest: 11.99%

demand: 1765.2875
L NL
linked demand to calculation 1412.23
$ 8,968.20 $ 7,351.97 linked to WACC 11.99%

L $ 9,695.27 $ 11,793.30

Airbus NL_NPV - L_NPV: $ (1,616.24)

$ 16,256.30 $ 14,043.32

NL $ - $ -

Figure 9: Demand Increase 25%

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Appendix 2: CPI Last 10 Years
Annual % AVG
1990 127.4 128 128.7 128.9 129.2 129.9 130.4 131.6 132.7 133.5 133.8 133.8 130.7 6.1 5.4
1991 134.6 134.8 135 135.2 135.6 136 136.2 136.6 137.2 137.4 137.8 137.9 136.2 3.1 4.2
1992 138.1 138.6 139.3 139.5 139.7 140.2 140.5 140.9 141.3 141.8 142 141.9 140.3 2.9 3
1993 142.6 143.1 143.6 144 144.2 144.4 144.4 144.8 145.1 145.7 145.8 145.8 144.5 2.7 3
1994 146.2 146.7 147.2 147.4 147.5 148 148.4 149 149.4 149.5 149.7 149.7 148.2 2.7 2.6
1995 150.3 150.9 151.4 151.9 152.2 152.5 152.5 152.9 153.2 153.7 153.6 153.5 152.4 2.5 2.8
1996 154.4 154.9 155.7 156.3 156.6 156.7 157 157.3 157.8 158.3 158.6 158.6 156.9 3.3 3
1997 159.1 159.6 160 160.2 160.1 160.3 160.5 160.8 161.2 161.6 161.5 161.3 160.5 1.7 2.3
1998 161.6 161.9 162.2 162.5 162.8 163 163.2 163.4 163.6 164 164 163.9 163 1.6 1.6
1999 164.3 164.5 165 166.2 166.2 166.2 166.7 167.1 167.9 168.2 168.3 168.3 166.6 2.7 2.2
2000 168.8 169.8 171.2 171.3 171.5 172.4 172.8 172.8 173.7 174 174.1 174 172.2 3.4 3.4

Average percentage change in CPI over last 10 3.045

years:
http://www.usinflationcalculator.com/inflation/consumer-price-index-and-annual-percent-changes-from-
1913-to-2008/

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References

Boeing. (1999). 1999 ANNUAL FINANCIAL REPORT. Retrieved from

http://boeing.com/companyoffices/financial/finreports/annual/99annualreport/BOEINGfi
n99AR .pdf

Fiscal Facts. (May 5, 2005). U.S. Lagging Behind OECD Corporate Tax Trends. Retrieved from
http://www.taxfoundation.org/news/show/1466.html

Voyle, R., Voyle, K. (1996). Assessing Skills and Discerning Calls. Retrieved from
http://www.clergyleadership.com/consulting/sermon.pdf

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