Reference no: EM133030989

Case 1: Capital Budgeting: Competition in the Aircraft Industry

In early 2018, Boeing was involved in a titanic struggle with European consortium Airbus SAS for dominance of the commercial aircraft industry. Airbus first committed to spend $16 billion to develop the A380, the largest plane ever built. Boeing countered by announcing that it would spend $6 billion on a super-efficient new plane, the 7E7 Dreamliner. Airbus then announced plans to spend another $6 billion on the A350, a competitor to the 7E7. Many detailed calculations went into these multi-billion-dollar investment decisions, development costs were estimated, the cost of each plane was forecasted, a sales price per plane was established, and the numbers of planes that would be sold through 2025 was predicted. 

Both companies projected negative cash flows for 5 or 6 years, then positive cash flows for the following 20 years.  Given their forecasted cash flows, both management decided that taking on the projects would increase their company's intrinsic value. Because the planes will compete with one another, either Boeing's or Airbus's forecast is probably incorrect. One will probably be a winner and the other a loser, and one set of stockholders is likely to be happy and the other unhappy. Projects like the A350, A380, A50, B30 and 7E7 receive a lot of attention, but Boeing, Airbus, and other companies make a great many more routine investment. 

Analysis/ Project	A350	A380	A50	B30	7E7
Payback Period	3 years	3 years	2.5 years	2.8 years	3.2 years
Discounted Payback Period	3.8 years	3.5 years	3.4 years	3.2 years	3.5 years
Net Present Value (RM'000)	4.15	3.85	4.45	4.08	4.37
Internal Rate of Return	12%	12.5%	12.8%	12.7%	13%
Modified Internal Rate of Return	14%	13.8%	13.5%	13.8%	13.2%
Profitability Index	1.4x	1.5x	1.45x	1.3x	1.35x

Notes: WACC=10%

Figure 1: Capital budgeting for the Boeing's project

Sources: Adapted and Modified from Brooks (2015), Financial Management: Core Concepts, Global Edition, 3^rd ed, Pearson and Nuno, (2017). Finance for Executives: A Practical Guide for Managers, 2^nd ed, NPV Publishing. 

Question 1

"...........projects like the A350, A380, A50, B30 and 7E7 receive a lot of attention, but Boeing, Airbus..............." The decisions on investment, which take time to mature, have to be based on the returns which that investment will make. Assess the projects with various prospective project's lifetime cash inflows and outflows for the potential returns that generated to meet a sufficient target as shown in figure 1. 

Question 2

Interpret the THREE (3) constraints and TWO (2) possible solutions of an investment appraisal used to determine whether Boeing's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure such as share, bond and retained earnings.