Cost of Capital for the 787 Dream

Liner
March 31st, 2009
BA 518
Submitted by:
Jason Makowski
Adeeb Molla

Table of Contents
Introduction................................................................................................................ 3

The Boeing 787 Dreamliner...................................................................................5

The 787 family:....................................................................................................... 6

Technology Advancement:...................................................................................... 7

Continuing Progress................................................................................................ 8

Competition: Airbus A350 XWB..............................................................................9

Conclusion................................................................................................................ 21

Works Cited.............................................................................................................. 24

Introduction
In the late 1990s Boeing set off to develop its next aircraft for the commercial
aviation market. Due to the stiff competition of the Airbus A330, Boeing felt the
need to come up with a replacement for the 767. Boeing considered three different
types of aircraft that it could produce. The first was an extended version of the 747
that would be more fuel efficient and would be able to compete with the new Airbus
A380. The second type of plane was the Sonic Cruiser, which was an aircraft
designed to fly faster. This plane however would not be fuel efficient and thus would
only be successful if passengers were willing to pay extra to get to their destination
quicker. The third type of aircraft was a medium sized fuel efficient aircraft capable
of short or long haul routes.
After the attacks on September 11, 2001, it was made clear to Boeing that a
medium sized fuel efficient aircraft was the best option. They called their new plane
the Boeing 7E7 which is now called the Boeing 787 Dreamliner. The aircraft is a midsized, wide-body, twin engine jet. It is capable of carrying between 210 and 330
passengers. Boeing has stated that it will be more fuel-efficient than earlier Boeing
airliners and will also be the first major airliner to use composite materials for most
of its construction (Norris, et. al, 2005). The 787 will also offer more standing
headroom, larger windows and bathrooms, and higher humidity--all features that
will benefit passengers regardless of seat configuration.
The commercial airline manufacturing market is dominated by Boeing and
Airbus. However, within the commercial airline industry manufacturing segment,
are several segments that are characterized by the type of aircraft, the numbers of

passengers carried, efficiency and range. The supply in these segments depends
on how each manufacturer projects the future demand and needs of customers and
air travelers (Norris, et. al, 2005).
For example, Airbus believes in the continuance of the hub-and-spoke system
and forecast increase in passengers; therefore, it has planned to enter the very
large aircraft market segment. Boeing however, concluded that there will be an
increase in point-to-point travel for which a medium sized aircraft would be ideal.
Marty Bentrott, vice president of sales, marketing and in-service support for the
787, says that since 1990, the number of city pairs more than 3,000 nautical miles
apart, and served by the world's airlines have doubled; the number of frequencies
offered by the airlines have doubled; and the number of available seat per
kilometers. None of these trends show any signs of demand for very large aircraft;
meanwhile, the average airplane size has actually declined slightly.
With the rising dominance of low-cost carrier and the strife of legacy airlines
to align their strategies with low-cost carriers, it is evident that point-to-point routes
are flown more frequently and are not served by very large aircraft. The hub-andspoke system constraints passengers needs and offer limited options. Therefore,
Boeing has implemented its strategy to keep passengers in mind whose options are
constrained by the strategies of the legacy carriers. "Our strategy has been to
design and build an airplane that will take passengers where they want to go, when
they want to go, without intermediate stops; do it efficiently while providing the
utmost comfort to passengers; and make it simple and cost-effective for airlines to
operate," Bentrott says (Babej, et Al, 2006).

Several studies conducted by Boeing have indicated that they tailor their
products to customers. They facilitated focus groups and conducted research, and
concluded different needs. With the 787, they have been able to manufacture a
product that could be generically tailored to any airline, and specifically customized
to any passenger needs. This type of strategies is useful when considering that
Boeing has been loosing market share to Airbus. With Airbus entering the VLA
market, Boeing was expected to loose even more market share. The new 787
ensured that Boeing reap some of the market share it has lost to Airbus and built
customer loyalty with the current customers.
It is a good time for Boeing to launch the 787 because it has the potential to
reduce fares in the long run. Such assumption is based on the decreasing operating
cost this aircraft may offer to customers; therefore, it also offers the possibility to
reduce fare prices. Moreover, when considering the ever increasing fuel prices, the
introduction of 787 will be an innovative approached to hedge fuel prices. Airlines
retrofitting the aircraft 757, 767, A300, A310, A321, and A330 can replace these
models with 787. These potential individual airlines may then achieve economies of
scale, scope, and density, which are characteristics of low-cost strategy.
Despite the values that the 787 may create, it is important to discuss the
value that this project may create. For example, the NPV and the internal rate of
return can be used to determine whether the project will add or subtract value to
Boeing Company. In addition, the projected annual cash flow could also be
discounted back to the present in order to determine the viability of the project. It
is important to find an appropriate discount rate to use these techniques. In this
case, the discount rate is the unlevered cost of all equity [Rf+beta * (market
premium)]. Therefore, finding the beta was the stepping stone to the case study.
5

Once we found the beta and computed the discount rate, we compared the discount
rate with the projected IRR.

The Boeing 787 Dreamliner

The Dreamliner has been the most successful new aircraft in the companys
history, even before it initial rollout from the Everett factor in Washington on July of
2007. The Dreamliner can fly long-ranges even though it is a midsize commercial
airplane. It also boasts fuel efficiency and provides for a smoother ride for
passengers and flight crew compared to the aircrafts it is going to replace. Boeing
is planning to manufacture three versions of the aircraft Boeing 787 -8, Boeing
787- 3 and Boeing 787 -3.
All versions of the Dreamliner will be mid-sized, wide-body, twin engine
jetliners. Boeing also plans to build a stretch version of the Boeing787 -9, model
named 787-10 which will seat more than 300 passengers. The 787-10 will be
available in 2013. Below is a comparison of the three versions of the Dreamliner .

The 787 family:

The 787 -8: is the base model and is similar to the Boeing 787-3 model
but has a longer wingspan for longer flights. It is made to replace midsize jets such as the Boeing 767 and Airbus A330.

The 787-3: it is the most unique of the three models because of the
wing and structure optimization for shorter-range flights. It is designed
to replace the Airbus A300, Boeing 757 -300 and the Boeing 767200/300.

The 787-9: is the stretch version of the 787-8 model with structural
strengthening, lengthened fuselage and a higher fuel capacity. It is to
replace the mid-size jets such as the Boeing 767 and Airbus A330.

Below is a chart that shows the aircraft specifications for each of the models.

Passengers
Range

787 -8

787-3

787-9

210-250

290-330*

250-290

7,650 to 8,200
nm

2,500 to 3,050
nm

8,000 to 8,500
nm

Cabin width

18 feet, 10 inches

Wing span

197 feet

170 feet

203 feet

Length

186 feet

186 feet

206 feet

Height

56 feet

Cruise speed
Max. takeoff
weight

Mach 0.85
484,000
pounds

Total cargo
volume

4,400 cubic feet

Entry into
service
Price in millions

364,000
pounds

540,000
pounds
5,400 cubic
feet

2008

2010

late 2010

$157 to $167

$146 to
$151.3

$189 to $200

Technology Advancement:
The key to this exceptional performance is a suite of new technologies being
developed by Boeing and its international technology development team. Boeing
has announced that as much as 50 percent of the primary structure -- including the
fuselage and wing -- on the 787 will be made of composite materials. An open
architecture will be at the heart of the 787's systems, which will be more simplified
than today's airplanes and offer increased functionality. Boeing has selected
General Electric and Rolls-Royce to develop engines for the new airplane. It is

expected that advances in engine technology will contribute as much as 8 percent

of the increased efficiency of the new airplane, representing a nearly twogeneration jump in technology for the middle of the market. Another improvement
in efficiency will come in the way the airplane is designed and built. New
technologies and processes are in development to help Boeing and its supplier
partners achieve unprecedented levels of performance at every phase of the
program.

Continuing Progress
The Boeing board of directors granted authority to offer the airplane for sale
in late 2003. Program launch occurred in April 2004 with a record order from AllNippon Airways. Since that time, 37 customers have placed orders for 460 airplanes
from five continents of the world, making this the most successful launch of a new
commercial airplane in Boeing's history.
The program has signed on 43 of the world's most capable top-tier supplier
partners and together finalized the airplane's configuration in September 2005.
These partners have started detailed design and, with Boeing, are connected
virtually at 135 sites around the world to work toward major assembly in 2006.
Eleven partners from around the world started facility construction for a total of 3
million additional square feet to create their major structures and bring the next
new airplane to market.

Competition: Airbus A350 XWB

Below are the specifications of the Airbus A350 models A350-800, A350-900
and the A350-1000.

A350-800

A350-900

A350-1000

Passengers

270-312

314-366

350-412

Range

8300 nm

8100 nm

8000nm

Cabin width
Length

19 feet, 4 inches
198 ft, 6 in

Height

Entry into
service
Price in millions

242 ft, 5 in

55 feet, 5 inches

Cruise speed
Max. takeoff
weight

219 ft, 3 in

Mach 0.85
540,000
pounds

580,000
pounds

650,000
pounds

2014

2013

2015

$196.5 to
$202

$228 to
$232.5

$256 to $261

According to Boeing the Dreamliner will be 20 percent more fuel efficient compared
to the mid-sized Boeing 767 or the Airbus A330 aircrafts.

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Engineering Advances
Boeing has a number of Engineeering Advances that are unique in an attempt
to set it apart in the market.
Composite body:
By using layers of carbon fiber reinforced plastic provides for a lighted
and more durable body than the traditional aluminum, which allows for
larger windows, higher cabin pressure and higher cabin humidity. A one
piece fuselage section eliminates 1,500 aluminum sheets and 40,000
to 50,000 fasteners.
Material benefits:
Composite materials are lighter and burn less fuel unlike metal. They
also dont fatigue or corrode which saves airlines a lot in maintenance
costs.
Air quality:
Removing contaminants from air and increasing humidity in the cabin
helps passengers feel better after a long flight (reducing the effects of
jetlag), was concluded in a 2 year study, and therefore Boeing took this
factor into account and has increased the air purification on the
Dreamliner.
Cabin pressure:
The Dreamliner is designed to handle higher cabin pressure compared
to other airlines. This higher pressure is achieved because of a stronger
composite body. This higher pressure in the cabin will leave passengers

feeling less tired after a flight.

Lighting:

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New LED lighting in the cabin will give the airline a wide range of
lighting to provide for the customer, such as illuminate the cabin
during boarding with the company colors, change lighting to soothe the
customer during take off and landings etc. Lighting can change any
time of the day from sunrise to sunset to starry skies which will help

acclimatize passengers to the time-zone they are flying into.

Windows:
o The Dreamliner will have the largest windows in the industry. A higher
level will give the passengers a better horizon view, it will not have the
traditional shades and the glass will be made from electro chromic
glass, which will dim at a touch of a button to the requirement of the
passenger.

787 Market:
Boeing claims that there is a trend away from the traditional hub and spoke
structure (i.e. between two major hubs) and a trend towards nonstop secondary
routes that don't need to connect through hubs. A 'high density' route would be, for
example, between London and Newark. A secondary route would be, for example,
between Cleveland and Madrid. Secondary routes generally don't need very large
aircraft due to the smaller number of passengers that fly on them.
We believe that this philosophy is correct for the most part, that there is
indeed a growth in secondary routes, but that this is only part of the issue at hand.
There is also a steady growth in all passenger traffic - Boeing itself predicts a growth
of more than 5% a year for many years into the future. Total passenger traffic will
double within the next ten to twenty years, and this growth, combined with finite
airport and runway capacity and limited numbers of 'slots' for flights in and out of
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airports, is pushing the need for bigger and bigger planes. Medium density routes
are becoming high density routes, and high density routes are becoming too-high
density. Congestion at airports and in the skies all increases the need for larger
capacity airplanes. While Boeing still maintains there is no market for such a big
plane, the orders that Airbus already has for the A380 shows that there may very
well be a substantial market for the super jumbo.

Financial analysis of the 787 project

Before Boeing made a go decision on the B787, they had to know if the
project was going to create value. Because their previous production, the B777 has
been a very costly investment, the Boeing board had to be sure that the 7E7 project
will be profitable for the company. Therefore the financial analysis of the 7E7 project
was a key element in the decision process and had to be done rigorously.
Michael Blair, Boeings Senior Vice President, presented the 7E7 Dream liner project
in 2003. Since the decision of launching the new Boeing 7E7 took place in 2003 we
will look at the data available at that time.
For this analysis, a 20-year forecast of free cash flow for the Boeing 787 has been
done. This forecast has been created from the public information released by
Boeing, Airbus, analysts and other experts in commercial air transportation. For this
forecast, we used the different assumptions made in the case; the principal
assumptions made are presented below:
-

2500 B787 sold in the first 20 years

Price of $136.95 million for the B787 and $170.87 million for the B787-

stretch
Development costs of $8 billion
Gross profit margin of 20%
13

The next chart represents the annual Free Cash Flow for the B787 project from 2004
to 2037 and the second chart is a representation of the estimated cumulative Free
Cash Flow. The second chart indicates a payback period of 10 years and 6 months.
$30,000.00
$25,000.00
$20,000.00
$15,000.00
$10,000.00
$5,000.00
$0.00
($5,000.00)

Free Cash Flow

14

$70,000.00
$60,000.00
$50,000.00
$40,000.00
$30,000.00
$20,000.00
$10,000.00
$0.00
($10,000.00)
($20,000.00)

From this forecast, we were able to deduce the Internal Rate of Return for the
Boeing 787 project. With the previous assumptions, we found an IRR of 9.01%, as
illustrated by the following chart:

$40,000.00
$35,000.00
$30,000.00
$25,000.00
$20,000.00
$15,000.00
$10,000.00
$5,000.00
$0.00
($5,000.00)
($10,000.00)

15

However, in order to know if this project is profitable to Boeing, we need to

compare this IRR to the required discount rate for Boeing. If the IRR is greater than
the appropriate discount rate then the project is viable and should be accepted. For
the discount rate, we will use Boeings Weighted-Average Cost of Capital (WACC).
The formula for the WACC is:

D
E

WACC (1 Tc )
rD rE
V
V

Because we are using the Capital Asset Pricing Model (CAPM), the cost of
equity RE depends on the beta () of the firm:

R E R f ( Rm R f )
Therefore we need to determine the beta for this project. However, in our
case, the for Boeing is given for the entire company, which is not representative
of the B787 project. In fact, Boeing is composed of two major divisions: the defense
division (Integrated Defense Systems) and the commercial aircraft division (Boeing
Commercial Airplanes). Since Boeing merged with McDonnell Douglas, each division
accounts for 50% of the companys total revenue, therefore we cannot simply
ignore the defense division for the estimation of . Because military contracts are
low risk, the companys overall beta is too low to account for a commercial aircraft
project.
We need to factor out the defense division beta from the Boeings beta.

Percent defense def Percent commercial com

def
In order to have an estimation of

for Boeing, we will use the beta from

companies like Lockheed Martin, Northrop Grumman and Raytheon. These

16

companies generate their revenues from defense contracts and will provide a good
estimation. However, to compare the beta from these different companies, we have
to unlever them first. This is because each company has a different capital
structure, so by unlevering the beta, we will be able to compare them without any
influence of the different capital structure of the companies. To unlever the beta, we
will use the following formula:

E
D

1 1 t

A
is called the asset beta

We will use the beta calculated against the S&P 500 to obtain the unlevered
beta for the different companies. We have the following table:
Boeing
Beta
Debt/Equity

Lockheed Northrop
Raytheon
Martin Grumman

0.8

0.36

0.34

0.43

0.525

0.41

0.64

0.624

def 0.28
The average Beta for Lockheed, Northrop and Raytheon is:

def 0.28
Therefore, we will assume that the beta for the Boeing defense division is
As a consequence, we can calculate the beta for commercial airplanes. We
have the following table for the source of revenue:

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 Percent defense def Percent commercial com

Using the formula

, we have:

0.6 47% 0.28 53% com com 0.88

com 0.88
Therefore, we have for the commercial division:
In order to use the Capital Asset Pricing Model, we have to lever the beta for
the commercial division, by using the following formula:

D
E com 1 1 t

E

E 1.185
We obtained:
To continue with the process of estimating the Weighted Average Cost of
Capital (WACC) we have to find the cost of equity and the cost of debt.

WACC

Debt
Equity
Rd (1 t )
RE
TotalCapital
TotalCapital

We first calculate the cost of equity (Re). We use the Capital Asset Pricing
Model (CAPM) and the formula is shown below.

R e R f ( Rm R f )

Because the B787 project has an estimated lifespan of 25 years, we will use
the rate of the thirty-year US Treasury bond as our risk-free rate (R f). As of June
2003, the yield on the U.S. Treasury bond was 4.56%. As we calculated before, the
has a value of 1.185. For the risk of the market (R m), we used the S&P 500 index
as a proxy for the market. 12.37%
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Using these values we get an Expected Rate of Return for Equity of 13.82%

R E 4.56 1.185 12.37 4.56 13.82%

The next calculation is for the cost of debt (Rd). We take the amount of debt
and the yield to maturity of those debts to obtain R d.

Rd

( DebtAmount *YTM )
DebtAmount

Once we have the cost of equity and the cost of debt we can obtain the
Weighted Average Cost of Capital.

E
RD (1 t )
R
E
V

V
WACC 34.43% 5.29% 1 .35 65.57% 13.82% 10.16%
WACC

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A way for Boeing to reduce the cost of capital is increasing debt. Since the R d
is less than Re, by increasing debt, equity will decrease and the WACC will be lower.
The WACC formula is very simple but different analysts get different results.
There are different reasons to explain this situation. One of them depends on the
analysis on the risk free rate since in this case we have two options, the Treasury
bill (three months) and the Treasury bond (three years). Another explanation for
this fact is the calculation of the . To find the we should get the percentage of
commercial and the percentage of defense and that might depends on the value we
do the percentage from, revenues or assets.
To know if the 787 project will create value we need to use capital budgeting
tools as the NPV and the IRR. Using the annual free cash flows from 2004 to 2037
and the WACC as the rate of discount we will estimate a negative NPV of $1687.48
million for the project. From the IRR perspective we see how the IRR is less than the
rate of discount (9.01% < 10.16%). With a NPV negative and the IRR less than the
rate of discount, we can say that project will not be profitable. But given that if
Boeing is able to raise the debt percentage in a way of issuing more bonds it can
gain a weighted average cost of capital more than the IRR. The magical percentage
figure is 42.78% of debt according to our calculations. Further more reconsidering
the current financial fact of Boeing it is visible that the Boeing 787 program has
raised more debt to increase its WACC. But at current level it is yet to show it self
financially significant since the production delays has added the total development
cost at $ 9 billion dollars thus decreasing the IRR.

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Looking at the sensitivity analysis we can see how the project is profitable for
any of the options shown below except for development costs above $9 billion and
cost of goods sold as a percentage of sales of 84%. That point shows an IRR of 8.6%
than would reflect negative results since is less than the

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Conclusion
Boeing chose to go ahead with the 787 project for a number of reasons. As we can
see from the analysis that this project was clearly not approved on financial analysis
alone without some ajdustments. There are several non-financial factors that
overrode the needs for the numbers and caused the board to approve the project.
Boeing believes that the hub-and-spoke system will not remain viable in the future
airline industry. The company forecasts an increase in point-to-point routes and
destinations. Passengers also prefer point-to-point travel over the hub-and-spoke
system, especially if they value their time. Boeing saw an opportunity to satisfy this
forecasted need with the 787. In addition, Airbus has penetrated the very large
aircraft (VLA) market segment with the A380. Therefore, Boeings dominance in the
VLA market segment has would be risky and effectively an uphill battle to come up
with something comparable. Airbus has also taken Boeings market share in other
smaller aircraft market segments. Therefore, these factors have been the driving
force to for Boeing to create something that is unique and innovative to maintain, or
even recapture its market share.
The financial ratios also show that Boeing has the potential to acquire more debt,
and eventually reduce its cost of capital. Other financial ratios indicate that Boeing
is more efficient than its rival, and Boeings management is more effective than its
rivals.
However, Boeing is not perfect. Its 787 global supply-chain management is not
without problems. Boeings global supply chain was planned well, but it did not use
the information it had on the risk factor of each supplier. Some suppliers, for
example, did not obtain funding on time in order to ensure that they design and
22

build major components on time. As a part of its redesigned supply chain, Boeing
contracted with suppliers to design and built major component of the 787, which are
then assembled in three days at the assembly plant in the state of Washington.
Unlike the previous supply chain, where suppliers has designed and built small
components, Boeing has hoped to decrease the assembly time to three days with
the new supply chain management. Therefore, it has been crucial to adopt an
optimal just-in-time inventory, where, the components arrive in the planned
chronological order at the planned time. The problem that Boeing has faced is that
the components have not arrived on time, in the right order, and with the proper
aerodynamic sub-components. Such minute errors have caused ripple effects, in
terms of delays, throughout the supply chain. Such mistakes, we feel are the in the
norm when a firm is trying something new, especially when the task is to coordinate
and assemble a commercial jetliner.
Boeing indicates that this will not happen again, and they will contract with more
reliable suppliers. Therefore, we recommend the board different alternatives. If
Boeing projects that the dollar continues to weaken against the currency of other
countries in which the suppliers are located, than it would be a good idea to
contract only suppliers located within the U.S.A. The rationale behind this
alternative is that when the production occurs in a country with currency that is
loosing value, the company may have a competitive advantage because the cost of
production is less unlike the cost the suppliers incur within other countries that have
currency that is appreciating against the dollar.
Another alternative that we recommend to the board is the use of operations
research. By using transportation models, Boeing can identify a site within or
outside the U.S that is closer to the suppliers. However, the risk of this alternative
23

entails the U.S government regulations that need to be considered and the distance
from home or central authority. Another alternative that Boeing has initiated is
the purchase of shares of the suppliers. In such case, Boeing has more control on
the processes and the timing of the manufacturing side of the components.
Any of these alternatives may modify the supply-chain management to some
degree and require additional cost to the company and especially to the 787
project. Even though the modification may increase cost, Boeing needs to increase
its debt load and change its capital structure; it will eventually reduce the cost of
capital. We have seen this happen already. Boeings debt load at current is larger
than it was when they were considering the project. We have assumed that they
decided to take on debt as the project was approved and foresee a profit due to this
change over the life of the project. What remains to be seen is the Airline Industrys
reaction to the 787 when it launches and whether it will prove to be the game
changer Boeing claims it to be.

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