Boeing 777 Project Group Report

Winter 2017
Corporate Finance
Professor: Dr. Samuel Hideyo Szewczyk

Group Number: 1

Participating Group Members:

Sami Chukrallah
Jackie Donovan
Roberto Maldonado
David Olsen
Bryan Uber
Michael Zimmerman

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Boeing 777
In October 1990, the Boeing Company announced that it was launching a new aircraft
model, the 777. The company praised the superior technology of the product and the fact
that it filled a gap in Boeing’s product line. Moreover, it was targeted to service routes in
a critical high growth market segment. The chief objective of the analysis is to evaluate
the 777 against a financial standard. The case gives internal rates of return (IRRs) for the
777 project base case and alternative forecasts. The principal analytical problem of the
case is an estimation of a weighted average cost of capital (WACC) for Boeing’s
commercial aircraft division in order to evaluate these IRRs. The analysis should also
identify ‘key value drivers’ and distinguish, on a qualitative basis, the key gambles
Boeing is making.

PART 1
Your decision on the Boeing 777 will be in the context of the nature of doing business in
the commercial air industry and the basic strategies for success in this industry.

1. Describe the aircraft industry. Characterize the nature of doing business in this
industry. What basic strategies are pursued in the industry?

The aircraft industry is a highly competitive market made up of three key companies:
The Boeing Company, McDonnell Douglas [MD], and Airbus Industrie. The industry
provides aircraft for consumption by private companies [Commercial Airlines] and
governments [Defense]. There are many different platforms that can be developed for the
two main consumers based on their applications. The market for commercial travel is
expected to increase by 5.2% per year throughout the next 15 years and increase to grow
10.6% to travel to Asia.
The nature of doing business in this industry revolves around the ability to deliver
products that fit the markets of commercial travel and government defense. The purpose
of this paper is to analyze the commercial travel portion of the market. Boeing has a plan
to build a new platform with the 777 model. In this model, the most important factors
are: ability to travel nautical miles and seating capacity. Models are developed with
seating capacity to be able to carry more passengers in a single trip. The ability to travel
long distances with a high capacity is very important. The companies that can deliver on
seating capacity as well as nautical miles are set up the best for success in the commercial
portion of the market. By targeting the fastest growing portion of the commercial
market with a product that fits seating capacity and nautical miles provides the best
opportunity for success. Lifetime of an aircraft is also a basic strategy of success in the
industry. The ability for a company to create a product that has a long life gives the best
opportunity for return. By standardizing some of your products, you are also able to limit
the maintenance costs due to the ability to mass produce parts that fit multiple platforms.

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2. Characterize the nature of risk taking in this industry.

The aircraft industry is very risky because of the outlay in capital. There are three
main competitors in the Commercial and Defense aircraft market: Airbus Industrie,
McDonnell Douglas, and Boeing.
The outlay of capital to research and develop a new aircraft is massive. When a
company decides to build a new aircraft it needs to have the right uses to fit the market
they are going for. Boeing is attempting to fill a larger area of the commercial travel
market by building the 777.
Political risk needs to be weighed when entering into a portion of the aircraft
industry. This includes both the defensive and commercial markets. When there is a war
in the Middle East, like the invasion of Kuwait, it drives up variable costs. Variable costs
may have a significant effect on the cost to build a new product or the cost to the
consumer. Depending on the location of the conflict, this could drive up material costs to
build and/or the costs to operate. If the costs of operating grow too large, the market
shrinks due to the general population not being able to afford airfare.
There are a limited number of competitors in this market due to the high cost of entry
and research/development. This limits the risk somewhat as there are only a few key
players to compete with. When reviewing the substitutes there are many alternatives to
travel, however the aircraft industry has the ability to travel great distances. The ability
to differentiate with a high nautical mile range and high capacity of passengers provides a
uniquely high return when the right product is introduced to the market.

In October 1990, the prime question was whether the Boeing 777 project remained a
sensible investment for Boeing. Political and economic conditions worsened. The
economy was slowing and entered into a recession in July 1990. On August 2, Iraq
invaded Kuwait. A major concern was the threat Iraq now posed to Saudi Arabia. The
United States assembled a coalition of forces to oppose Iraq’s aggression. Iraq had the
world’s fourth largest army and could field one million troops and 850,000 reservists,
4,500 tanks, 3,000 artillery pieces, and 700 combat aircraft and helicopters. Opposing
them in Saudi Arabia was a coalition force of 956,600 troops. The question at the time of
the case was not if war would break out (fighting began on January 17, 1991); but how
destructive and far reaching the impending war would be to the region’s oil fields,
pipelines, and port facilities. Would there be a major disruption in the flow of oil from
the Persian Gulf? Also, could the war deepen the recession?

3. Boeing’s concern is the impact of the war and its aftermath on the prospects for the
Boeing 777 project. On one hand, the war could have a long term impact on oil
prices/fuel prices and air travel. On the other hand, its impact could be relatively short
lived, especially if the battlefield could be contained and the damage to the oil fields
and facilities limited. Perhaps one could look back in history at the oil crisis that
followed the 1973 Arab-Israeli War and its negative economic impact on the decade.
Which future scenario would be deemed most likely in October 1990?

With an economic recession underway and a war in the Middle East on the horizon,
most global industries have cause to pause and hypothesize the potential effects. After

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the economic impact of the 1973 Arab-Israeli War, industries directly impacted by the
price of oil are especially sensitive to the potential effects. However, a spike in the price
of oil was not the only cause for concern this time around. With the surge of commercial
airline traffic in the 1980’s, it was likely this would decelerate as a result of the political
and economic climate. This two-pronged impact posed a serious concern for the
sensibility of the Boeing 777 project.
The United States’ support for Israel during the 1973 Arab-Israeli War caused the
Organization of Petroleum Exporting Countries (OPEC) to initiate an oil embargo. The
oil embargo punished the U.S. by cutting off oil exports. As a result, oil prices in the
U.S. soared and the economy experienced a downturn.
While Saudi Arabia lead the oil embargo initiative, politics had shifted by the time of
the Persian Gulf War. The U.S. and Saudi Arabia were now allies.1 The concern was not
another oil embargo. Rather, the potential destruction to the region’s oil field, pipelines,
port facilities and the impending disruption in the flow of oil. Any disruption in the flow
of oil would be certain to raise the price per barrel and aggravate the recession.
As the case study explains, the increase in passenger air traffic had a direct impact on
the growth in aircraft demand. Passenger air traffic surged in the 1980’s. Deregulation
of the airline industry eased the barriers to entry, creating more competition and driving
prices down. As a result, record numbers of passengers were flying commercially.2 With
Iraq’s invasion of Kuwait, “fuel prices had risen, passenger air traffic had declined, the
inflow of aircraft orders had stopped, and several airlines had canceled existing orders”.
The boom of the 1980’s had come to a screeching halt.
The United States’ support to Israel during the 1973 Arab-Israeli War was in the form
of supplying weapons.3 During the Persian Gulf War, the United States was a participant.
There was much at stake for the United States’ both economically and politically. The
United States’ participation in the Persian Gulf War would support the hypothesis that the
outcome was much more in our control. With the best military in the world, there was
sufficient reason to believe that damage to the oil fields and facilities would be limited.
Throughout history we have seen economic growth correspond with war time. An
increase in government spending on the military can lead to economic growth and job
creation.4 Economic growth will likely jump start consumer spending on items including
air travel. Therefore, despite the recession and Persian Gulf War, there is reason to
believe that the U.S. involvement and the corresponding increase in government spending
will impede long term negative impact on the economy and the viability of the Boeing
777 project.

1
Myre, Greg. "The 1973 Arab Oil Embargo: The Old Rules No Longer Apply." NPR. NPR, 16 Oct. 2013. Web. 12
Mar. 2017.

2 U.S. Department of State. U.S. Department of State, n.d. Web. 12 Mar. 2017.

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3 "The Airline Industry." The Airline Industry. N.p., n.d. Web. 12 Mar. 2017.

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4 U.S. Department of State. U.S. Department of State, n.d. Web. 12 Mar. 2017.

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5 http://economicsandpeace.org/wp-content/uploads/2015/06/The-Economic-Consequences-of-War-on-US-
Economy_0.pdf

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A financial analysis of the project will examine the strategic fit of the project and its
importance to the firm. An important part of the analysis is evaluating the project’s
strengths, weaknesses, opportunities, and threats. We should also hear the opinions of
outside industry analysts and take note of the firm’s share price in the financial market.

4. Why is the 777 project important and how important? How does it fit into Boeing’s
commercial aircraft strategy?

The 777 project was crucial in the eyes of Boeing as it would fit a niche market of
medium-to-large passenger airframes and would carry 350 to 390 passengers up to 7,600
nautical miles, making it the largest and longest-haul aircraft available on the market. The
aircraft would also offer the customer flexibility in interior seating capacity and design,
along with the best cost efficiency of all its competitor offerings. The aircraft was being
designed with the vision of significant market demand growth for flights by 2005, which
would create a large demand for increased capacity. Moreover, Boeing saw a potential of
replacing aging fielded large passenger aircrafts with the 777 increasing its demand. This
market demand growth was expected to be approximately 5.2% over the next 15 years,
generating $615 billion in sales. Boeing has strived to dominate the commercial market
segment and remain atop with 50% + market shares, and the 777 project was the aircraft
to enable them to maintain and grow that market share.

5. Evaluate the project’s SWOTs (strengths, weaknesses, opportunities, and threats).

Strengths
The release of the 777 would make it the largest, longest-haul aircraft available to
the customers on the market. This allows Boeing to operate in a niche market and is
advantageous to the future sales and growth.
Boeings existing market presence makes it the most dominant airframer at 53%
market share. Boeing also has a remarkably strong balance sheet with book value of debt
making up only 4% of total capital and is able to support the spending in R&D and
capital expenditure to bring the 777 into market.
Boeings has the ability to leverage lessons learned cutting down on production
costs. An example of that is allowing designers to work closely with engineers upfront to
limit the amount of costly rework in the design necessary downstream. Furthermore,
Boeings capability to leverage significant technology transfers from the defense R&D to
commercial aircraft segment cuts R&D costs while increasing innovation in the
commercial world.

Weaknesses
Boeings large expenditures on engineering training, $2.5 billion over the next few
years, R&D expenses as high as $4 to $5 billion, and capital spending on new facilities of
nearly $1.5 billion means significant revenues are required to make the 777 program a
success. The company will have to endure years of cash outflow before breaking even.
Working closely with customers to tailor an aircraft to their specific needs may be
viewed as a weakness in the event the customer withdraws from the agreement to
purchase the aircraft due to economic downturns, especially when the product life cycle

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is anywhere from 12-20 years to production and anything can happen during this time.
Customers might also be able to leverage this to their advantage and negotiate a lower
price point, knowing that any costs Boeing has incurred in this specific tailoring would
result in sunk costs to the company.

Opportunities
With worldwide air traffic expected to increase at a rate of 5.2%/yr nationwide,
and 10.6%/yr in Asia over the next 15 years and the market need for a large long range
hauling aircraft, the 777 was going to be a great opportunity for Boeing to capitalize on.
Through CAD/CAM engineers can fully simulate the production of the 777. Bugs
can be found and eliminated before the aircraft enters production, this approach allows
Boeing to save as much as 20% of the 777 estimated $4 to $5 billion development costs.
The release of the 777 would also complete Boeings full family of aircraft and
may bring along several derivatives for potential future growth opportunities.

Threats
Competitors Airbus Industries release of the A330/A340 models and McDonnell
Douglas’s release of the MD-11 may put downward pressure on the 777 prices. The 777
hinges on generating significant revenues to counteract the R&D, capital and production
spending required to bring this aircraft to market.
The Gulf War has applied some upwards pressure on fuel prices resulting in a
decrease in travel. While the long-term association between economic growth and aircraft
orders tended to be quite stable, the health of the commercial airlines tended to be a
major determinant of aircraft orders in the short-term airlines could postpone purchases
for a couple of years, creating havoc in the finances of airframers.
The industry’s sensitivity to consumer and business confidence drives variation and
impacts future output in the short term, which may reduce working capital and result in
possible cash flow issues.

6. What are the views of industry analysts regarding the Boeing 777 project? Do they
have reasons for optimism? What are their concerns?

Industry reviews of the 777 appeared optimistic and elaborated on Boeing introducing
new technology and strategy to provide a competitive advantage over its competitors.
The 777 would feature a folding wing tip which would enable it to fit into the smaller
slots in airport terminals. This would leverage the plane’s ability to transport high
volumes of customers. The Boeing 777 would be equipped with fly-by-wire technology
which was being used by its competitor Airbus. Boeing’s strategy to ensure the success
of the 777 was to have six of Boeing’s major customers involved in the development of
the plane. Executives believed this would provide a competitive advantage over the
competitors Airbus and McDonnell Douglas. In addition, Boeing invested millions of
dollars on computer aided drawing and manufacturing (CAD/CAM) to work out every
detail prior to building the 777. This would save the company a projected 20% of the
777’s estimated $4 billion to $5 billion development cost.
With these enhanced features and automation, the expenditures were projected to
significantly increase. Specifically, the new facilities and training costs were projected to

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be $2.5 billion. In addition, the projected price of the 777 was expected to be reduced by
30% due to competitors in the same market space. While this 30% decrease is significant,
Boeing was projecting to sell 1,000 units at $100 million dollars.

7. Consider the graph of Boeing’s share prices compared to the S&P 500 over the period
January 1986 through October 29, 1990 in case Exhibit 10. Boeing’s share prices
appear to have tracked closely with the S&P 500 until about January 1990. The graph
of Boeing’s share prices on page 200 of the case looks more closely at the period
January 1990 through October 29, 1990. Is the market telling us something about
Boeing and the Boeing 777 project?

Between January 1990 and October 29, 1990, (Table 1)the investors responded to
Boeing because the Net Present Value (NPV) was above the Security Market Line
(SML). This occurred because Boeing was introducing a new product. This placed a
higher return above the company’s produced risk and was above the SML.

Table 1

Boeing’s stock was undervalued as a result of the 777 project becoming public
knowledge. When this became apparent the stock price exceeded the return of the S&P
500. This can be illustrated in the week 09 lecture found in table 2 below. The public
identified that the 777 project had value that exceeded the SML line and apparent risk of
the company.

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 Table 2

The base-case internal rate of return (IRR) for the Boeing 777 project is 19 percent,
calculated from the cash flows of the financial forecasts provided in Exhibit 6. The IRR
decision rule compares the project’s IRR to the project’s cost of capital. An acceptable
project has an IRR greater than its cost of capital. The principal analytical problem of
the case is an estimation of a weighted average cost of capital (WACC) for Boeing’s
commercial aircraft division which shall proxy for the cost of capital of the Boeing 777
project. Boeing consists of two divisions – the commercial aircraft division and the
defense division.

8. Exhibit 8 illustrates the payback periods (breakeven points) from the project’s
accumulated cash flows discounted at different WACCs. The exhibit gives us an
indication of how sensitive the project’s evaluation is to different values of the
WACC. If the WACC is 10%, what is the approximate breakeven point in years? If
the WACC is 20%, does the project have a breakeven point?

If the WACC is 10%, Boeing will have a breakeven point in roughly 12 years and a
steady increase thereafter up to roughly 5 billion. If the calculations are correct, investors
will support the production of the new product based on the profit margin1. If the WACC
is 20% the project does not reach a breakeven point. The project will plateau at
approximately 24 years. This indicates that the project will never show a profit or reach

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the breakeven point. However, the DCF does not take into consideration the re-
assessment of the project over its time in production. Issues in design or function will
cause changes. It also does not take into consideration of Boeing’s other departments.
With the war in Iraq focus had to shift from civilian transportation to military aircraft.
The war would also cause increase in production of parts which can result in cheaper
costs for Boeing once the war ended.

9. According to the case: ‘The growth in aircraft demand was a function of increases in
passenger air traffic, which in turn was a function of economic growth. Air traffic
was highly sensitive to variations in consumer and business confidence (page 201).’
Would you say that the beta of the commercial aircraft division is likely to be less
than, equal to, or greater than 1? The historical return on the market is about 11.7%.
Is it possible that the Boeing 777 project’s cost of capital could be as high as 20% (or
even higher)?

Firms, Utilities and Airlines are usually considered to have a Beta less than 1. This is
attributed to the industry’s demand which is not impacted by market variation.
Consumers will continue to use airline regards of other economic changes. 1 Yes. It is
possible to have the cost of capital to be greater than 20%. This is determined by
executive management in order to ensure shareholder value. With the current market at
11.7% and the scale of the 777 project, management could determine a cost of capital that
is greater than 20%. This would be dependent on the economic conditions and the
amount of risk the company is willing to absorb.

10. Which of Boeing’s divisions would you expect to have greater market risk – the
commercial air division or the defense division?

The case states that the war has turned against the project Boeing 777 project due to
the effects that the war has had on passenger travel (p. 199). It references a Value Line
quote stating that: “Boeing stock has pummeled since Iraq’s invasion of Kuwait.” (p.
199). In addition, Boeing’s defense division had been unprofitable in recent years and its
role within the organization was to support the more profitable and growth prone
commercial division. Therefore, one would expect that the commercial division would
have a higher market risk since market equity seems to be more closely tied to the overall
market performance. This expectation is supported by β commercial (calculation shown in
exhibit 1), which shows that at a value of 0.624 is much more sensitive to market
volatility than the defense division, which shows a βdefense of 0.376.

11. Why use the commercial aircraft division’s cost of capital and not Boeing’s overall
company cost of capital (what systematic bias would result when accepting and
rejecting projects using Boeing’s company cost of capital)? Would using Boeing’s
company cost of capital create a bias toward accepting or rejecting the Boeing 777
project?

The commercial aircraft division’s cost of capital is much higher than Boeing’s
overall company cost of capital because the commercial aircraft division projects are

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much riskier. If Boeing’s overall company cost of capital was used, there could be a
misinterpretation of the commercial division project’s risk which would lead to false
acceptance of the project by incorrectly assessing it as a lower risk project. This
systematic bias can be minimized by using the commercial division’s cost of capital so
that more correct decisions can be made to accept or reject a project based on its
investment risk.

PART 2
12. From information contained in the exhibits, what is the market value of Boeing’s
debt? What is the market value of Boeing’s equity?

Boeing has $271,500,000.00 in outstanding debt in the form of bonds and

$14,896,760,000.00 in equity in the form of common Stock

13. According to the case: ‘Boeing has historically shown an aversion to debt financing
with the book value of debt making up only 4 percent of total capital (page 201)’.
Based on your market values, what is the market value weight for the cost of equity in
the WACC for the commercial air division?

The cost of equity on the commercial air division is 98.21%

What is the market value weight for the cost of debt?

The market value weight for the cost of debt is 1.79%

Do you think these values fairly reflect Boeing’s target capital structure?

Yes, they are the market numbers and not historical book values.

According to the case: ‘Analysts were predicting that Boeing would increase the debt
ratio to 14 percent over the next year or so because of future financing needs (page
201)’. Would this alter your estimate of Boeing’s target capital structure?

14. From information contained in the exhibits, what is your estimate of the cost of debt
in the WACC?

9.67%, We take the weighted average of the multiple bonds.

a. What is the firm's market capital structure?    

Common Stock
Market value of Equity $ 14,896.76 Outstanding shares times price per share
Bonds
Market value of Debt $ 271.50 Par value times price as percent of face times bonds
Firm

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 Market value of Firm $ 15,168.26 Market value of equity plus market value of debt
Market Value Weights
Equity Weight 98.21% Market value of equity divided by Market Value of Firm
Debt Weight 1.79% Market value of debt divided by Market Value of Firm

b. If project was same risk as the firm, what rate should the firm use to discount the project's cash flows?

Cost of Equity
Risk-free rate 0.09 T-bill yield
Market risk premium 0.05
Beta 1.00
Cost of Equity 0.14 CAPM
Market Value Weights
Equity Weight 0.98
Debt Weight* 0.01

Firms WACC
WACC 14.08%

* Referencing the course material, when taking multiple securities, you take the weighted
average to determine the cost of debt.

15. The problematic estimate is the cost of equity for the commercial air division? The
cost of equity in the case is estimated using the Capital Asset Pricing Model (CAPM).
From information on page 204, what are the proxies for the risk-free rate and market
risk premium that will be used in the CAPM estimates?

Due to the different risks associated with each division (commercial being higher
risk, defense being more stable) which is reflected by their different betas. Therefore, it is
important to isolate the contribution of the more volatile commercial division to calculate
the cost of equity for the commercial air division.

The project has an expected maturity time of 20 years. To match long maturity of this
project with adequate proxies for risk free rate a yield on T-bond with long maturity
should be chosen. In this case, the best one would be the 30-year Treasury bond (5.4%).

16. Exhibit 9 provides various betas estimated from regressions using stock returns and
the returns on a market index. The regressions present a choice between using the
S&P 500 index and the NYSE composite index (DataStream uses its own composite
index, but no information on this index is given in the case). Which index would you
choose to proxy for the market portfolio in the CAPM and why?

Based on Warren Buffet’s bet against hedge funds to beat the S&P 500 over a 10-year
period, we choose the 58-month time frame to calculate the CAPM. This value is close to

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the value line and DataStream line betas which are based on the company’s actual
performance.

17. The regressions are either estimated over long estimation periods (four years, five
years, and 58 months) or over short estimation periods (12 months and 60 days). In
general, what is the advantage and disadvantage of a long estimation period? What is
the advantage and disadvantage of a short estimation period?

Long Estimation Period

Advantage: Gives a long-term picture. Shows risk beyond economic and political
strife. Investments typically become less risky over longer estimation periods. If the
WACC is less than the IRR, it would be in the interest of the shareholders to move
forward with the project.
Disadvantage: Potentially outdated representation of the market conditions.

Short Estimation Period

Advantage: Heavily influenced by current market conditions. Further, if the current
market conditions are good but potential issues are years away, it could calculate as
lower value of bet that could become riskier over a longer period.
Disadvantage: Heavily influenced by current market conditions. Results could be
impartial since they are affected by economic and political noise without time for the
overall climate to equalize. Investments are typically riskier when calculated during
shorter estimation periods.

18. The graph of Boeing’s share prices on page 200 shows increased volatility in the
share price after Iraq’s invasion of Kuwait? The volatility could be an increase in
noise due to increased uncertainty or the stock price changes could reflect new
information. If it is predominately noise, would you use a long-term estimation period
for the regression or a short-term period? If it is new information, would you use a
long-term estimation period or a short-term period?

If it is predominately noise, we would use a long-term estimation period for the

regression analysis. This would allow the market to get beyond the uncertainty of the
war and its impact on the national and international economy. The goal with a long-term
estimation period would be to move past the noise to a more stable market.

If it is new information, we would use a short-term estimation period. New

information’s impact needs to be immediately understood with regards to the calculation
of beta. Use of a short-term estimation period would allow results to bore out the impact
of new information on the market.

19. Is it noise or information? The beta of Boeing reflects the market risks of its
commercial aircraft division and its defense division. The other firms are largely

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 defense firms. Note the change in the beta of Boeing as it moves from long-term to
short-term estimation periods. Note the change in the betas of the defense firms as
they move from long-term to short-term estimation periods. Can you infer anything
about changes in the market’s assessment of the market risk of Boeing’s commercial
air division following the invasion of Kuwait from these beta changes?

Exhibit 9 is a victim of noise. As pointed out in the article and question, the
aggregate change in betas can be misleading considering most are defense firms.
However, the change in the market’s assessment of the market risk of Boeing’s
commercial air division following the invasion of Kuwait is explicit. While the other
firms experience a gradual decrease in beta as it moves from short estimation period to a
long estimation period, Boeing’s beta is more than double in the 60 day period and about
double in the 12 month period. This is a signal that the market saw investments or
companies in the commercial airline market to be riskier as a result of the invasion of
Kuwait. The invasion of Kuwait caused major impacts on the political and economic
environments. However, this is noise in the short estimation period. As discussed in the
response to Question 3, the direct involvement of the United States’ military and the
increase in government spending are likely to have positive impacts on the political and
economic climate. Therefore, using a longer estimation period (58 months) allows the
regression analysis to get beyond the noise to a point where the market could get back to
a more equalized state.

We want to calculate the WACC of the commercial aircraft division and use that WACC
to evaluate the Boeing 777 project. We need a beta for the commercial aircraft division
to estimate the division’s cost of equity. However, the case does not provide that beta.
But we can estimate it as follows: The beta of a firm is a value weighted average of the
betas of its divisions (the firm can be thought of as a portfolio of divisions). We have the
data to estimate the beta of Boeing’s defense division using the pure play firm method.
Knowing Boeing’s company beta, the beta of its defense division, and the market value
weights of the divisions, we can solve for the beta of its commercial aircraft division.

20. Pure play firms are firms whose principal line of business is the same as the division
or project. Among the firms in Exhibit 9, which pure play firms did you choose to
estimate the beta of Boeing’s defense division? Did you reject any potential pure play
firms?

After analyzing Exhibit 9, it was decided to use Grumman, Northrop and Lockheed to
estimate the beta of Boeing’s defense division. This conclusion was reached by analyzing
the estimated betas. A Pure play firms are firms whose principle line of business is the
same as the division or project. It was determined that the estimated betas calculated
against the S&P 500 and the NYSE were not a good representation when compared to the
Statistical services. The statistical service calculations were based off of the company’s
performance over the past five years and a regression analysis over the past four years.
This led to the decision of choosing Grumman, Northrop and Lockheed because the value
line had an average Beta Equity of 1.02, which was in close proximity of the estimated
beta for Boeing. McDonnell Douglas was rejected due to the distribution of its divisions

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(66%) and estimated betas on the value line, when compared to Grumman, Northrop and
Lockheed.

21. Based on your answers to questions 20 through 23, which betas in Exhibit 9 should
you use given their market indices and their regression estimation periods?

Grumman, Northrop and Lockheed should use the Betas based on the market indices and
their regression estimation periods.

22. Calculate an estimate for the beta of the defense division using the pure play firm
method. Unlever and relever the betas using the Hamada formula.

Unlevered Calculations:
βlevered
Grumman: βunlevered=
Debt
1+ (1−T )
Equity
0.95
βunlevered= =0.44
1+ ( 1−0.34 )∗1.756
βlevered
Northrop : βunlevered=
Debt
1+ ( 1−T )
Equity
1.00
βunlevered= =0.54
1+ ( 1−0.34 )∗1.288
βlevered
Lockheed : βunlevered=
Debt
1+ ( 1−T )
Equity
1.10
βunlevered= =0.62
1+ ( 1−0.34 )∗1.182

Levered Calculations:
Debt
Grumman: βlevered=βunlevered∗1+ ( 1−T )
Equity
¿ βunlevered∗1+ (1−0.34 )∗1.756=0.95
Debt
Northrop : βlevered=βunlevered∗1+ ( 1−T )
Equity
¿ βunlevered∗1+ (1−0.34 )∗1.288=1.00
Debt
Lockheed : βlevered=βunlevered∗1+ ( 1−T )
Equity
¿ βunlevered∗1+ (1−0.34 )∗1.182=1.10

23. We don’t have the market values of the commercial aircraft and defense divisions.
So, we proxy the market value weights in the portfolio calculation using accounting
data. Exhibit 1 provides the revenues, operating profits, and identifiable assets (book
values) by division for the Boeing Company. Which of these possibilities could serve
as a reasonable proxy for the market values of the divisions? Which did you choose?

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 In order to serve as a reasonable proxy for market value of the divisions, one should
use Revenue and Operating Profit. These categories were chosen because market value is
the price at which willing buyers and sellers would trade the assets. The book value is
equivalent to Identifiable Assets. This is why we have chosen to use Revenue and
Operating Profit to determine the amount of debt. The difference between the Revenue
and Profit would equal the amount of debt that would be equivalent to market value.

24. Given Boeing’s company beta, your beta for the defense division, and the portfolio
weights, calculate the beta for the commercial aircraft division. What is your beta for
the commercial aircraft division?

Please see Exhibit 1.

β Boeing= % defense×β defense +% commercial ×β commercial

βBoeing = 1.0, estimated β from Value Line calculation (p.214)

1.0 = 26% x 0.376 + 74% x

β commercial

β commercial = 1.219

25. Using the CAPM, calculate the cost of equity for the commercial aircraft division.
What is your cost of equity?

Cost of equity= .054 + 0.81 (0.082-0.054)

Cost of equitycommercial= 0.077

26. Calculate the WACC for the commercial aircraft division and compare it to the IRR
of the Boeing 777 project. What is your WACC? What does the WACC indicate
about the Boeing 777 project?

Boeing estimates to sell 1,000 units at $130,000,000.00 each.  This means their IRR
was 18.9% which is greater than the WACC of 14.08%. The rate of return is greater
than the cost.  Boeing should move forward with this investment should the market
continue and maintain its course.

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Exhibit 7 provides a sensitivity analysis of the project’s IRR. The upper table evaluates
assumptions regarding unit price and unit volume (market share). The lower table
evaluates cost assumptions - research and development expenses and general, selling, &
administrative costs.

27. Under what circumstances is the Boeing 777 project economically attractive?

A key determinant of the Boeing 777 project economical attractiveness is Boeings cost of
capital. The IRR rule states that if the internal rate of return on a project is greater
than the minimum required rate of return, or cost of capital, then the project or
investment should be pursued. In this event the forecasted IRR in the base case is 18.9%
based on the assumption 1000 aircrafts will be sold at a cost of $130M per unit to the
customer. At a 18.9% IRR and a calculated WACC at 14.08% the project is
economically attractive as IRR exceeds WACC.

28. What does the sensitivity analysis reveal about the nature of Boeing’s gamble of the
Boeing 777?

Four key determinants impact Boeings financial forecasts on the projects returns. The
determinants are Sales Volume, Unit Price, Research and Development (R&D), and
General Selling and Administrative expenses (GS&A).

Sales Volume and Unit Price sensitivity analysis matrix reveals the following,

Pessimis Expecte Optimis

  tic d tic
Unit Volume 700 1000 1200
Unit Price $100M $130M $130M
IRR 13.90% 18.90% 20.60%
Excerpt from Exhibit 7, with target IRR highlighted in RED

GS&A sales and R&D Expenses/Sales sensitivity analysis matrix reveals the following,

Pessimisti Optimisti
Expected
  c c
GS&A Sales 7% 4% 1%
R&D
Expenses/Sales 5% 3% 1%
IRR 13.50% 18.90% 23.50%
Excerpt from Exhibit 7, with target IRR highlighted in RED

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Baseline
If Boeings forecasting is accurate the projects estimated internal rate of return is
18.9%. This is based on the assumption that Boeing maintains its existing market share of
53% and future market demand results in a growth of 5.2% over the next 15 years, all
other factors held constant. Factors that may skew the 777 IRR are competition,
economic stability, gas prices, actual market demand.

Pessimistic
Considering a worst case scenario where competitors like Airbus Industries and
McDonnell Douglas’s release the A330/A340 and MD-11 respectively, aircrafts that may
compete and operate within the same segment the 777 would, may result in downward
pressure on the 777 prices. The most pessimistic outlook would result in a reduced
market share for Boeing dropping 300 units from the forecasted baseline volume of 1000
units to 700 units. The downward pressure on prices due to the competition would result
in a decrease of $30 Million in unit prices, from $130 Million baseline to $100 Million
per aircraft sales price. This combined worst case pessimistic outlook reduces the projects
IRR by 5%, from 18.9% to 13.9% making the investment economically unattractive as
WACC exceeds IRR.

Similarly, in the event Boeing cannot capitalize on R&D investments made in the
defense segment which would have propagated into the commercial 777. Failing to
leverage that R&D would result in further expenditure on GS&A and would result in a
worst case scenario of R&D expense to sales ratio of 5%, and an increase in GS&A from
4% to 7%. This combined worst case pessimistic outlook reduces the projects IRR by
5.4% from 18.9% to 13.5% making the investment economically unattractive as WACC
exceeds IRR.

Optimistic
On the flip side, if the competition fails to introduce an aircraft that would
compete for Boeings market shares in that segment, Boeing will be able to sell the 777 at
$130 Million per unit, all else constant, and possibly expand sales volumes over the
forecasted 1000 units, up to 1200 units depending on worldwide economic conditions and
stability. This combined optimistic outlook would result in an IRR increase of 1.7%, from
18.9% to 20.6%, making the investment economically attractive as IRR exceeds WACC.

Similarly, in the event Boeing is able to leverage its defense R&D and implement
its lessons learned on the 777, that would result in lower GS&A expenditure decreasing
from 4% to 1%, and a lower R&D expense to sales ratio of 1%. This combined optimistic
outlook would result in an IRR increase of 4.6%, from 18.9% to 23.50%, making the
investment economically attractive as IRR exceeds WACC.

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29. The project may be managed to produce a desired outcome? In what ways is Boeing
managing the project to ensure getting a premium price for the 777 and capturing
their traditional market share?

Boeing is managing the project by keeping both R&D and production costs low,
through actions such as implementing CAD/CAM so that engineers can fully simulate the
production of the 777 prior actual build. Bugs can be found and eliminated before the
aircraft enters production, this approach allows Boeing to save as much as 20% of the
777 estimated $4 to $5 billion development costs. Similarly leveraging lessons learned on
defense programs and carrying that technology over to the commercial segment allows
Boeing to cut development as well as GS&A costs down.

30. Are there significant values not captured by this discounted cash flow analysis?

There are significant values not captured by the Discounted Cash Flow (DCF). DCF
determines how much cash Boing will have after all obligations have been settled but
does not take into account changes in production methods or changes in interest rates.
Another issue with DCF is that it will proceed with the calculations established on day 1
for the life of the project. Over the course of the project production, costs, time on project
and staff on project can adjust which changes the original calculations. The longer you
project out the more uncertainty lies within your projection. DCF also ignores your
competition. Does your competition speed up production, do they have a major setback,
and have you or your competition discovered a new technology that puts one ahead of
another in both time and quality of product. DCF also does not take into account the
increase in production time your team will have as it becomes comfortable with the new
project.

31. What would you recommend that Frank Shontz do? Summarize the reasons for your
recommendation.

Advancement in technologies, customer needs and maximizing profits is the success to

any organization. It is our recommendation that Boeing move forward with the 777
project and along the way find new ways to improve the already existing lineup of
aircraft.
Boeings current fleet cannot keep up with the growing passenger population. The
days of the flying few are rapidly decreasing. The current flying hesitation will soon give
way to convenience of air travel and aircraft will be full once again. Air travel is
becoming the new daily commute for not only the wealthy, but the working class. With
the addition of the 777 Boeing can maximize the amount of passengers on major flights,
reducing flights, while maintaining or increasing passenger numbers.
Boeing’s IRR for the 777 project are as low as 13.90% to a high of 20.60% with
an expected rate of 18.90%. With the expected rate of 18.90% it is in Boeing’s best
interest and strategic advantage to move forward with the production of the 777 aircraft.

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Exhibit 1

β levered
β unlevered =
debt
1+(1-t )
equity

Grumman Northrop Lockheed

% Revenues from Defense 0.87 0.89 0.85
S&P 500 12 month  Levered 0.73 0.72 0.69
Market-Value D/E 1.756 1.288 1.182
Tax Rate 0.34 0.34 0.34
1+ (1-T)* D/E 2.15896 1.85008 1.78012
 Unlevered Defense division 0.338 0.389 0.388

(
β defense =β unlevered × 1+(1-t )
debt
equity)=0. 372 ×( 1+(1-0. 34 )× 0 .018 )=0 . 376

β Boeing= % defense ×β defense +% commercial ×β commercial (solve for β

commercial)
βBoeing = 1.0, estimated β from Value Line calculation (p.214)

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