Answers to Boeing's Case Study

CASE 16

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THE BOEING 7E7

Teaching Note

Synopsis and Objectives

In 2003, the Boeing Company announced plans to

build a new “super–efficient” commercial jet called the “7E7”

or “Dreamliner.” This was a “bet the farm” gamble by

Boeing, similar in magnitude to its earlier introductions of

the 747 and 777 airliners. The technological superiority of

the new airframe, as well as the fact that it would penetrate a

rapidly growing market segment, were arguments for

approval of the project. On the other hand, the current market for commercial airplanes was

depressed because of terrorism risks, war, and SARS, a contagious illness that resulted in global

travel warnings. Boeing’s board of directors would need to weigh those considerations before

granting final approval to proceed with the project.

The task for students is to evaluate the 7E7 project against a financial standard, the

investors’ required returns. The case gives internal rates of return (IRR) for the 7E7 project under

base-case and alternative forecasts. The students must estimate a weighted-average cost of

capital (WACC) for Boeing’s commercial-aircraft business segment in order to evaluate the

IRRs. As a result of that analysis, the students identify the key value drivers and distinguish, on a

qualitative basis, the key gambles that Boeing is making.

The general objective of this case is to exercise students’ skills in estimating a weighted–

average cost of capital and cost of equity. The need for students to estimate a segment WACC

draws out their abilities to critique different estimates of beta and to manipulate the levered-beta

formulas. Boeing competes in both the commercial aircraft and the defense business. Thus,

deriving the appropriate benchmark WACC for the 7E7 project requires isolating the commercial

aircraft component from Boeing’s overall corporate WACC. In doing so, students engage the

concept of value additivity.

Suggestions for complementary

cases on the cost of capital:

“Teletech Corporation, 1996”

(Case 15); “Nike Inc.” (Case 14)

and “Coke vs. Pepsi” (UVA-F-

1340)

156 Case 16 The Boeing 7E7

Tip: The instructor can streamline

the discussion considerably by

dictating “base–case” assumptions

for student use regarding cost of

debt, risk-free rate, and equity

market risk premium. Such

direction could be offered in the

assignment questions. Our

preference is not to dictate very

much, but rather, to let students

explore alternatives. The balance of

this note follows this path.

However, many schools have a

“house view” about the equity

market risk premium. For this

reason, the case does not cite an

EMRP—the instructor is assumed to

offer guidance here. At the date of

the case, the four main estimates of

EMRP were:

• 6.4%

(geometric mean over T-bills)

• 4.7%

(geometric mean over T-bonds)

• 8.4%

(arithmetic mean over T-bills)

• 6.4%

(arithmetic mean over T-bonds)

See the Appendix for definition and

discussion of the geometric and

arithmetic EMRPs. The calculation

in Exhibit TN8 illustrates the use of

the arithmetic mean over T-bills.

Suggested Questions for Advance Assignment to Students

1. What is an appropriate required rate of return against

which to evaluate the prospective IRRs from the

Boeing 7E7?

a. Please use the capital asset pricing model to

estimate the cost of equity. At the date of the case,

the 74-year equity market risk premium (EMRP)

was estimated to be ___. Which beta and risk-free

rate did you use? Why?

b. When you used the capital asset pricing model,

which risk-premium and risk-free rate did you

use? Why?

c. Which capital-structure weights did you use?

Why?

2. Judged against your WACC, how attractive is the

Boeing 7E7 project?

a. Under what circumstances is the project

economically attractive?

b. What does sensitivity analysis (your own and/or

that shown in the case) reveal about the nature of

Boeing’s gamble on the 7E7?

3. Should the board approve the 7E7?

Supporting Excel Spreadsheets

Student analysis of the case is supported by the spreadsheet file, “Case_16.xls,” available

from Darden Business Publishing (sales@dardenbusinesspublishing.com). Instructor analysis is

supported by “TN_16.xls.” It is a condition of accessing this file that you agree not to share the

contents of the instructor file with students.

Hypothetical Teaching Plan

The following questions offer an outline for discussion leadership. These can be easily

condensed or expanded to meet a discussion time as short as 80 minutes and as long as 4 hours,

depending on the depth to which the instructor wishes to address the issues.

Case 16 The Boeing 7E7 157

1. Why is Boeing contemplating the launch of the 7E7 project? Is this a good time to do so?

This opening summarizes the basic facts, broad motives for the project, and the risks. The

objective for this part of the discussion is to set the tone for the case discussion, especially the

need to prepare a recommendation for Boeing’s board of directors.

2. Should Boeing’s Board approve the 7E7?

The instructor can take the students’ vote and then solicit a few opinions and summarize

key arguments on the chalkboard. One can ask specific students for their estimate of the cost of

capital and write it next to their yes or no vote. The students will show some division of opinion,

but in our classroom experience, they tended to lean toward approval. The instructor could easily

take a “devil’s advocate” approach toward the prevailing sentiment and invite defense of the

students’ opinions. In any event, acknowledgment of a range of estimates builds drama and

confirms that there are competing views among students—this motivates a detailed discussion of

the financial analysis.

3. How would we know if the 7E7 project will create value?

Students may be familiar with the classic NPV criterion. This case invites them to focus

on the internal rate of return (IRR). If the IRR is greater than the project cost of capital, the 7E7

is a positive net present value project.

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A discussion of why this is true provides a solid “big

picture” foundation for the case decision. The project IRRs are presented in case Exhibit 9.

Therefore, the focus of student analysis should be on determining the benchmark against which

to evaluate the IRRs. Thus, this part of the discussion helps to motivate the analysis of WACC.

Some students may have voted in a manner that contradicts the IRR versus the cost of capital

decision rule. This sets up the next question.

4. Okay, let’s examine the details of how to estimate the WACC. Let’s go step-by-step.

Where shall we get started?

The instructor can ask one student (or team of students) to walk the class through the

detailed calculations. The presenter(s) may make one or more errors or adopt some controversial

practice in making the calculations. This presents a strategic teaching question for the instructor:

interrupt and correct at the first mistake, or do it after they are done? The latter is preferable if

you are in a discussion-based learning environment. Thus, the instructor could keep a careful

record of the students’ calculations on the chalkboard,

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let them finish, and then turn to the class

and ask, “Do you all agree? Why not?” Challenges and debates over specific issues will follow.

At this point, it is not important to judge the quality of the assumptions (they can be good or

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Of course, this assumes initial negative cash flows followed by positive cash flows.

2

This class is ideally suited for the chalkboard. PowerPoint or other digital media make it difficult to

summarize the complete analytic process in plain view of the students and simply puts the success of the whole class

in the hands of the presenters. The instructor needs to remain in control of the discussion—continuing to hold the

chalk is the best way to do this.

158 Case 16 The Boeing 7E7

bad). The task of the instructor is to work through the WACC calculation in an orderly manner.

A number of thought-provoking questions about techniques can lead to rich classroom

discussions. By the close of this segment of the discussion, the instructor should aim to have on

the chalkboard a finished WACC calculation that highlights aspects about which there may be

some disagreement.

5. The weighted-average cost of capital is a simple formula. Yet it seems that reasonable

people can disagree about the estimates. How can there be such a range of cost of capital

estimates? Please summarize the issues.

This segment asks the students to summarize the thorny questions of estimating WACC

and to contrast the issues in practice with the underlying simplicity of the weighted-average cost

of capital formula and the capital asset pricing model. The reason for varying estimates is that

students will have made different assumptions as they apply the formula. This will be apparent

on the chalkboard if the instructor has faithfully recorded the assumptions of the main

presenter(s) and any alternate assumptions that may have surfaced. The next step is to do

sensitivity analysis on each assumption. If the sensitivity analysis reveals that the decision

outcome is significantly impacted by the assumption, only then is it worth spending more time,

energy, and dollars on improving the quality of the assumption. This is another judgment part of

financial analysis and decision-making. A good analyst will make the board aware of critical

assumptions, so that it can, in turn, make more informed and better decisions.

6. Have we thought of everything? Is there anything else the board of directors should

consider in assessing the financial appeal of this project? Why might the board vote

“yes” on the 7E7, when the cost of capital estimate is greater than the IRR? Why might

the Board vote “no” if the cost of capital estimate is less than the IRR?

This segment of the discussion should aim to introduce the basic idea that determinate

cash flow forecasts do not capture contingent values. Real option valuation is beyond the scope

of this case, but students should be reminded that a large capital project such as the 7E7 is

probably riddled with rights that can enhance the value of the project—rights to new yet-to-be

discovered technology, rights to grow and/or enter new markets, and rights to cross-pollinate

other projects’ new intellectual property from the 7E7. In addition, the 7E7 might create

intangible value for Boeing’s brand and strategic value for cross-selling. The potential

significance of qualitative issues can be an eye-opening point for some students who consider

finance to be a “numbers” class. In the end, the board of directors must weigh both the

determinate cash flow values and the contingent and intangible values in the project.

7. What should the board do?

The instructor could bring closure to the discussion with another student vote. Making

careful note of students who may have changed their minds, the instructor could invite one or

two to comment on what they learned. Airing the reasoning behind some of the vote changes will

reinforce the learning objectives underlying the decision-making process.

Case 16 The Boeing 7E7 159

Question 1: Why is

Boeing contemplating the

launch of the 7E7 project?

Is this a good time to do

so?

Question 4: Let us

examine the details of how

to estimate the WACC. Let

us go step–by-step. Where

shall we get started?

The instructor could close the class with a brief commentary on development of the 7E7

project since the date of the case. The epilogue presented in this note recounts the board’s

decision to proceed with the 7E7 project. Further developments may be gleaned from Boeing’s

Web site and others.

Case Analysis: Estimation of the Project-Specific WACC

Launch and timing of the 7E7

The motives for the project are laudable: the 7E7 is entering

a good growth segment of the industry. Higher performance and fuel

efficiency will position Boeing favorably in the market, and perhaps,

take back some market share from competitors. R&D on this project

may create inventions that will prove to be valuable to other Boeing

products. At the same time, the consequences of error are staggering:

this is a bet-the-ranch kind of investment.

But, as most entertainers know, timing is everything. Here, the timing could not be

worse: war, airline-focused terrorism, SARS, and the weak financial condition of airlines all

challenge the approval of the project. “Why now?” is a question that the board must answer. In

part, the answer depends on the long development cycle (four years) and very long product

lifecycle (20 years). The board is making a bet less on conditions that prevail today than on

conditions that are expected to prevail many years into the future.

Calculating WACC

The instructor could use the formulas for WACC and the

capital asset pricing model as a format for organizing the calculation

section of the discussion.

1. WACC = (% debt)(rd)(1 – tc) + (% equity)(re)

where: rd = required rate of return of debt

re = required rate of return on equity (cost of equity)

tc = marginal effective corporate tax rate

% debt = debt divided by sum of debt plus equity, measured at market value

% equity = equity divided by sum of debt plus equity, measured at market

value. Market value of equity is simply share price times number of shares.

Many analysts simply approximate market value of debt with its face or book

value. In most instances, this is not an unreasonable practice: for floating-rate

debt issues (such as bank loans) market value will equal book value; for fixed–

rate issues, book value may be a close substitute for market value, where the

160 Case 16 The Boeing 7E7

Question 5. The weighted-average

cost of capital is a simple formula.

Yet it seems that reasonable people

will disagree about the estimates.

What are the points of contention in

estimating the cost of capital?

Please summarize the issues.

bond was issued at face value, and the credit quality of the issuer and the

general level of interest rates have not changed since date of issue.

2. Calculating the cost of equity (re)

Per the CAPM, re = rf + βe (rm – rf)

Where rf is the risk-free rate, rm – rf is the market-risk premium and βe is the beta of

equity.

One can leave the formulas on the board so that students are

able to see what the class is working toward, as a simple

organizing framework; but this simplicity is deceptive. The

theory says relatively little about the practical application of

those models. Reasoning from first principles, one can make

good headway in estimating the cost of capital. The kinds of

issues that will occupy the student include the following:

Choice of models: Students may wonder why the capital asset pricing model is not used

to estimate the firm’s cost of capital directly. The answer is that it can be used in such a fashion,

but in practice is almost never used for that purpose. A true asset beta is unobservable because

the items on the left-hand side of the balance sheet are ordinarily not traded in liquid markets. In

theory, one could derive a beta for debt and a beta for equity and then weight them according to

the market values of their securities—this should give an estimate for the firm’s asset beta.

Alternatively, one could unlever the equity beta to get an asset beta. Inserting the asset beta into

the CAPM would, in theory, yield an estimate of the firm’s cost of capital. But these latter two

methods invite estimation error. A survey of “best practice” firms,

3

however, revealed a total

preference for using the WACC formula and for restricting CAPM to estimating the cost of

equity.

Beta for the 7E7 project: The tendency of novices will be to use Boeing’s equity beta

from case Exhibit 10 as an input to the CAPM. This would be inappropriate since this would

assume that Boeing’s commercial aircraft risk is equal to Boeing’s firm risk. However, Boeing’s

firm risk is a blend of both commercial and defense risk. Somehow, for the cost of capital to be

meaningful we have to back out the commercial risk from the defense risk and use a beta

reflecting commercial risk in the CAPM. The class could discuss whether one would expect a

commercial beta to be higher or lower than a defense beta and why—a strong case could be

made that defense would have a lower beta, reflecting the zero default risk of Boeing’s

government clients and the long cost-plus contracts. It is useful to exercise students’ intuition

about risk.

3

See the study ‘Best Practices’ in “Estimating the Cost of Capital: Survey and Synthesis,” Financial Practice

and Education (Spring/Summer 1998) by Robert F. Bruner, Kenneth M. Eades, Robert S. Harris, and Robert C.

Higgins.

Case 16 The Boeing 7E7 161

Estimates of beta: Case Exhibit 10 poses two basic choices: first, what to use as a proxy

for the market when regressing equity returns on market returns; and second, over what period of

time the beta should be measured.

Ideally, beta should be derived by regressing Boeing’s equity return against the return on

the basket of global assets (i.e., the market return). Measuring the return on the global asset

portfolio is, as a practical matter, proxied by returns on equity market indexes. In bridging theory

with practice, the greater the value captured by the index, the more closely it matches the theory.

In case Exhibit 10, students have a choice between the New York Stock Exchange (NYSE)

composite index and the S&P 500 index. Of those two, the NYSE is a broader and higher value

index. This provides a beta range between 1.00 and 1.62.

Next, students have to choose whether to estimate beta across the 60-day, 21-month, or 5-

year period. Beta is the market’s instantaneous perception of risk and moves on a second by

second basis just like stock prices. However, since this is unobservable, we are forced to use

historic data to estimate the market’s perception of risk today. The question therefore is what

historic period best reflects the risk of the commercial aircraft industry as perceived by the

market at the time of the decision?

Using a 60-day beta regression includes the trading dates between March 20 and June 16,

2003. This time period includes the Iraq war as well as the peak of the SARS travel warnings.

The 21-month beta runs from September 17, 2001, and therefore includes significantly more

terrorism risk. The 60-month beta dilutes terrorism, war, and SARS risk by going as far back as