SEMINAR IN FINANCE (TASK 4)

By:
Alti Asri Ladiba Disan 00000004347
Carrina Chittra 00000002182
Ignatius Mario 1305000977
Irka Dewi Tanemaru 00000000670
Iswandi 1305000510
Nikolas Sulistio 1305002790

FACULTY OF BUSINESS AND ECONOMIC

UNIVERSITAS PELITA HARAPAN
KARAWACI
2017
 The Boeing 7E7
Background
Early in 2003, Boeing announced their plan to design and sell their new designed product, the Boeing
7E7. However, the news over the next six months depressed the market for aircraft. The United States
and Iraq are in the war state, spasms of global terrorism, deadly illness called SARS that resulted in global
travel warnings. The airline profit was at their lowest point back then. Nevertheless, Michael Bair, the
leader of the 7E7 project announced that Boeing was making an excellent progress on the development of
the 7E7 and continues to be on track to seek authority to offer the airplane. For the project to go well,
Bair needs to convince the board of directors in early 2004 by starting to collect orders from airlines and
expect passengers to start flying on the new jets in 2008.
Origins of the 7E7 Project
Boeing had not introduced any commercial aircraft since it rolled out the highly successful Boeing 777 in
1994. In the 1990s, Boeing announced and then cancelled two new commercial-aircraft programs, which
the most prominent was called Sonic Cruiser, that is promised to fly 15% to 20% faster than any
commercial aircraft. Unfortunately, Boeing received messages from their clients, saying that passengers
are not willing to pay premium prices to have a faster ride. Now Boeing needs to develop a product that
would pull the financial slump and the sales loss over the years to Airbus, its chief rival. 7E7 are capable
of doing short and long trips with 200 and 250 passengers, with 20% less fuel than existing planes, which
even 10% cheaper to operate than Airbus A330-200. Boeing promised composites would also reduce its
manufacturing costs, with goal to design a plane with fewer components that could be assembled in 3 days
as opposed to the current 20 days that it took to rivet together the Boeing 767. Analysts argued that
building a plane that would do short hops in Asia and long trans-Atlantic flights would require two
versions of the plane with different wingspans. Boeing engineers considered the possibility of snap on
wing extensions. The question was whether this would be too costly, as well as being technically feasible.
Another major concern was that two of the 11-person board, Harry Stonecipher and John Mcdonnell have
raised serious concerns regarding the cost of the 7E7. While the cost of developing the 7E7 project could
be as high as $10 billion, there was an imminent veto threat if that number did not shrink by billions. The
board wanted to keep 7E7 development costs down to only 40$ of what it took to develop the 777.
Additional pressure from the board was to keep the 7E7 per-copy costs to only 60% of the 777 costs.

Commercial-Aircraft Industry
Boeing and Airbus dominated the large plane commercial-aircraft industry in 2002. Being historically
leads the market through number of measures Airbus became number one. In 2002, Airbus received 233
commercial orders compared to Boeings 176, representing 57% unit market share and an estimated
53.5% dollar value market share.
Airbus has a huge growth, since established in 1970, it took 23 years to deliver its first 1000 aircrafts, then
another six years to deliver the next 1000, and three years to deliver the next 1000. In 1999, Airbus has
sold more planes than its rival, Boeing.
While Boeing was split into two primary segments, the commercial airplanes and integrated defense
systems. Firstly, it was awarded $16.6 billion in defense contracts, then $17.0 billion to Lockheed Martin.
A study shows that Boeing has invested significant amounts of technology to the defense R&D, which
makes him loss a huge amount of sales on the commercial-aircraft segment. The commercial-aircraft
segment produced and sold six main airframes, 3 for the short-range markets, and 3 for the long-range
markets. As of December 31, 2002, Boeing undelivered units under firm order of 1083 commercial
aircraft and had a declining backlog of about $68 billion. For 2003, it projected 280 commercial-aircraft
deliveries and expected between 275 and 300 in 2004. In 2003, Boeing estimated the revenue would reach
$22 billion for the commercial-aircraft segment, down from $288 billion at 2002. Since the incident of 11 th
September, Boeing cuts down the production rates in half for 2002 to maintain profitability in that
segment.
Exhibit 2 and 3 show Boeings balance sheet and income statement. We need to know that the earnings
from 2001 to 2002 are significantly decreasing because of the accounting change (SFAS No. 142).
However, the drop in commercial-airplane deliveries from 527 to 381 in 2001 to 2002 also contributed to
the decline.
Demand for Commercial Aircraft
Boeings Market Outlook said that in the short term, air travel is influenced by business cycles, consumer
confidence, and exogenous events. Over the long term, cycles smooth out, GDP, international trade, lower
fares, and network service improvements become paramount. During the next 20 years, economies will
grow annually by 3.2% and air travel will continue its historic relationship with GDP by growing at an
average annual rate of 5.1%.
Exhibit 4 shows that Boeing forecasts to 2022, for 24,276 new commercial aircraft in 2002, valued at $1.9
trillion. The prediction reflected a world fleet that would more than double, with one-fourth of the market
coming from aircraft replacement and three-fourths from projected passenger and cargo growth. Exhibit 5
illustrated Airbus 20-year predictions for the ears 2000-2020. Boeing and Airbus numbers are not head to
head because its different timeline, but it appeared that Airbus was more optimistic about the market for
large aircraft than Boeing was. Airbus predicted it to be a $270 billion market with 1138 passenger units,
while Boeing projected $214 billion with 653 passenger units. According to recent study by Frost &
Sullivan, they believed that the Airbus market projection for the A380 was over-optimistic.
Aircraft Development and Lifecycle
Development of a new airframe was characterized by huge initial cash outflows with around one to two
decades to recoup. Pricing would be subject to rigorous, competitive pressures. In short, the financial
strains a new product line might create, each new aircraft was a bet the ranch proposition. Aircraft sales
were subject to short-term cyclical deviations with some degree of predictability in sales. Sales were
known to peak shortly after the introduction of the new aircraft, and then fall. Then it would rise and fall
as derivatives of the aircraft were offered.
The 7E7
The 7E7 was a design driven by customers requirements. Initially, Boeing plans to build faster aircraft,
the Sonic Cruiser. Its success would be highly depended on whether the passengers would pay a premium
price for a faster flight. However, after a lot of time, effort, and money are wasted, the customers only
need a plane with lower operating costs. Based on discussions with over 40 airlines across the globe, Bair
identified a fresh market to replace mid-size planes, with lower operating costs and ability to travel long
distances, which previously viable by only large planes. If Boeing could really fulfill its promise on
cutting 20% cheaper fuel costs and range flexibility in mid-size aircraft, it would be a huge success for
Boeing. In this case, Boeing would face an engineering uncertainty, and the risk of its duplication by
Airbus.
Financial Forecast and Analysis
Exhibit 8 is the 20-year forecast of free cash flow from Boeing 7E7 project. The primary implication of
the forecast is that the 7E7 project would provide an internal rate of return (IRR) close to 16%. Means
Boeing would not only deliver plane specifications, but that Airbus would be unable to replicate the 7E7
efficiencies. Based on the analysts and Boeings expectations, Boeing could sell 2500 units in the first 20
years of delivery. With careful attention to details and assumptions created, Boeing forecasted that
customers would be willing to pay 5% price premium for the lower operating costs. IRR was 15.7%,
which is consistent with the base case assumptions. But, the IRR was sensitive to variations in different
assumptions. For example, if Boeing only sold 1,500 units in the first 20 years, the IRR would drop to
11% (Exhibit 9). These additional unknown variables were the development costs and the per-copy costs
to build 7E7. The forecast assumes $8 billion for development costs, where analyst estimates a $6 billion
to $10 billion range. The cost to manufacture the 7E7 was also subject to great uncertainty.
Cost of Capital
Boeings weighted average cost of capital (WACC) could be estimated using:
WACC = (percent Debt) (rd) (1 tc) + (percent Equity) (re)
Where:
rd = Pretax cost of debt capital
 tc = Marginal effective corporate tax rate
% Debt = Proportion of debt in a market value capital structure
re = Cost of equity capital
Percent Equity= Proportion of equity in a market value capital structure
While Boeings marginal effective tax rate had been smaller in the past, it currently was expected to be
35%. The yield on the three-month U.S. Treasury bill was 0.85 in June 2003, where the stock price closed
at $36.41 at June 16, 2003. Analysts emphasizes that Boeing consisted of two separate businesses: the
relatively more stable defense business and the conversely more volatile commercial business. Due to the
terrorist attacks on September 11, 2001, the United States wars against Iraq on March 20, 2003, and the
travel warnings China announced from the deadly and contagious illness that subsequently spread to
Canada and Australia; the question arose of whether one should estimate Boeings cost of capital to serve
a benchmark required rate of return.

Conclusion
The magnitude of risk posed by the launching of a major new aircraft was accepted as a matter of course
within the aircraft-manufacturing industry. There was no guarantee of success or major significant losses
if the gamble did not pay off. At a time of political and economic uncertainty, Michael Bair said that it was
clear that Boeing needs to make a compelling business proposition. It could mean that Boeing will still be
in a terrible business climate in 2004. But you cant let whats happening today cause you to make bad
decisions for this very long business cycle. This plane is very important for Boeings future. Bair
recommend Boeings board of directors for the economic profitability of the 7E7 project.

Questions
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?
CAPM model
ra rf a (rm rf )
where:
ra : expected return of an asset

rf
: risk free rate
 a : beta of the security
rm: expected market return
So we get estimated cost equity for Boeing 7E7 is:

We use three-month U.S. Treasury bill for risk-free rate that is 0.85% because it represents the
condition at that time more precisely. For beta, we use information from Exhibit 10. We first
have to choose which proxy for the market when regressing equity returns on market returns;
second, what period of time the beta should be measured. For the period of time, we choose 60
trading days beta, because there are so many fluctuations in the market in the recent years, so
historic data may not reflect the future well. For the proxy, we choose NYSE because it has a
broader and higher value index that may reflect the market closely.
74-year equity market risk premium (EMRP) was estimated to be 8.4%, which is arithmetic
mean over T-bills.
b. When you used the capital asset pricing model, which risk-premium and risk-free rate
did you use? Why?
We use risk-premium for 74-year equity market risk premium (EMRP) because its been
investigated for a long time.
And for risk-free rate, we use three-month U.S. Treasury bill because it shows present time
more precisely like we said before.
c. Which capital-structure weights did you use? Why?
For this we use WACC because WACC calculates firms cost of capital in which each category
of capital is proportionally weighted and WACC is the average of the costs of these sources of
financing, each of which is weighted by its respective use in the given situation. So we think
that WACC is the best method to determine capital-structure weights.
2. Judged against your WACC, how attractive is the Boeing 7E7 project?
Total debt: 44,646
Total equity: 7,696
Total debt and equity: 52,342
Marginal tax rate: 35%
Cost of equity: 13.08%
Total debt Total interest Total equity
WACC 1 Tax cost of equity
Total debt and equity Total debt Total debt and equity
 44, 646 730 7, 696
WACC 1 0.35 0.13081
52,342 44, 646 52,342
0.02829876 2.83%
WACC is the calculation for giving investors an estimation on profitability and being able to
weight future projects. The highest WACC give the best result for the return on investment for the
company. For this Boeing 7E7, there is a lot of debt compare to equity, so the WACC result is just
2.83%, which is not so high but it is better.
a. Under what circumstances is the project economically attractive?
The project would be economically attractive if Boeing could sell enough planes in a given
time period above a certain price. For the market demand, the United States has had some of
the lowest passenger numbers in recent history. There are several factors to these lower
numbers. A decrease in business travel has occurred due to cost and the advance of the
technology. Lastly, the weak economy make people rethink about travelling abroad. Which
they can local travelling by not using airplane. For the market share, Boeings biggest
competitor is Airbus. It is a bit crucial for the new 7E7 delivers on its promise of lower
operating cost. This will help the company to attract much more investor so the company can
make a larger share in the market. This become even more important if the economy doesnt
recover quickly.
b. What does sensitivity analysis (your own and/or that shown in the case) reveal about the
nature of Boeings gamble on the 7E7?
Nature of Boeings gamble on the 7E7 is high because with the given of the information based
on exhibit 9, they forecast development cost would be $8,000,000,000 with 80% COGS/Sales.
The best case IRR is 21.3% with the development cost is $6,000,000,000 and the worst case is
8.6% with the development cost is $10,000,000,000, it means that the Boeings gamble is high
because of the differences relatively high and the variace of the IRR is 12.7 which mean that,
wrong choice in the development cost that we choose, could make the IRR that we will get is
lower even we have the probability that the IRR is higher.
3. Should the board approve the 7E7?
To make a strategic decision, the board should consider several aspects. In this case we are
going to focus on the financial and market aspect.
Market:
The industry leader in airplanes are Airbus and Boeing. In fact, Boeing had lost
over the yearts to Airbus in commercial-airlines segment, evethough the integrated defense
 systems airplanes showed positive growth from year to year. Perhaps without the 7E7,
Boeing would essentially relinquish permanent and dominant control of this industry.
Considering the current condition about the war, defensed airlines systems, SARS,
etc are slightly describing the lack of demand in airplanes or travel. On the other hand, the
needs of humans are still to strive for the more efficient and effective method. Yes, we get
the message that passengers were not willing to pay a premium price for a faster ride but
like Steve Jobs always said, People dont know what they want, until we show it to them.
This is the golden opportunity for Boeing to seize and make a breakthrough in airlines and
engineering industry.
Financial:
We cannot go blindly make a decision based on the potential market growth. The
quantitative analysis through financial aspect could help. First, we should understand how
the economy grow for the next 20 years- is observed because the lifecycle in airlines
industry. Boeing Market Outlook stated that during the next 20 years, economies will grow
annually by 3,2% and air travel will grow correspondently with the growth of GDP at an
average annual rate of 5,1%. The difference gap still tolerable for such case.
Moving on to the cash flow analysis form Ex. 8, we can see that the annul free cash
flow shows negative result from 2004, even untill the first delivery time in 2008, and
continue to be negative until 2010. As we sum up the, its approximately $5,000 we should
be prepared to spare. But based on the forecasting assumptions, it takes another 5 year to
generate the minus amount to be break even. As the lifecycle keeps rolling, we can
generate annual free cash flow and generate revenues better. The amount of IRR and
WACC we have, also show a promising potential for such investment.The strength point
from Boeing instead of Airbus, Boeing still have another primary segment that can support
the company, if any case, bad things happen in this 7E7 project.