Airbus challenge the Boeing 747, which had
Airbus A3XX: Developing the World’s Largest Commercial Jet Introduction: From its inception in 1970, Airbus has maintained a reputation for innovative design and technology.
Airbus has employed a “fly-by-wire” technology on all of its planes as an efficient alternative to computerized control for mechanical linkages. In addition, Airbus streamlined operations and features that have lead to better pilot utilization and lower training costs. These advances help explain why Airbus had received over half of the total large aircraft orders for the first time in 1999.
Although gaining market share, Airbus faced intense rivalry with The Boeing Company, whose unique importance in the US economy as a whole and rich history allowed it to become the world’s leading producer of commercial aircraft. In the late 1990’s, looking to gain market share within the very large commercial airplane market and gain a competitive advantage against Boeing, Airbus was faced with a capital budgeting decision of whether or not to proceed in building the world’s largest commercial jet, the A3XX. The A3XX would aim to challenge the Boeing 747, which had held a monopoly of the Very Large Aircraft (VLA) market for the last 30 years.In order to make the decision of whether to take on this project, Airbus needed to find out the net present value of this investment. In this case, our team used both weighted average cost of capital (WACC) and flow to equity (FTE) to analysis the whole undertaking.
Assumptions Before getting into more details about the expected financial return from the investment, we need to clarify several key issues. First, the investment in the A3XX is incredibly complex and we have, by necessity, used assumptions to simplify the case to build a more tractable model. For the whole market, we assume a risk free rate of 6.
% and this would remain a constant as well as the market premium (from information on the European market in 2000, we assume the market risk premium would be 6. 0%). Also, we assumed there would be a stable inflation rate which remains 2. 0% for the following years. Since we only know that Airbus expected to deliver the first planes in 2006, in 2008 it would reach its full production capacity of just over four planes per month and the estimate price per plane in 2008 is $225 million, we use the inflation rate to figure out the estimated prices for other years.We also assumed the production capacity would be 25% and 75% for 2006 and 2007, respectively. In order to give a conservative estimation, we use a 15% as our operating margin.
Another key issue in this case is the capital structure of the project funding. The A3XX would cost approximately $13 billion to launch, not including an estimated $700 million that would already have been spent by the end of 2000. Funding would come from risk-sharing partners (RSPs), launch aid from various governments and from the Airbus partners themselves in proportion to their ownership interests.The capital from Airbus partners is treated as part debt and part equity and the debt-to-equity ratio of the original company is used to figure out the exact amount; the launch aid and risk-sharing partners’ capital would resemble cumulative preferred stock rather than debt in that re-payment would occur on a per-plane basis, when and if Airbus was selling. In other words, if Airbus failed to make any airplane sales, both the RSPs and the governments providing aid would not receive anything from the firm.
Along those same lines, the case notes that “according to EU rules, launch aid had to be repaid within 17 years and had to earn a market rate of return. Historically, similar to the risk sharing capital, launch aid repayment came through on a per plane fee and non-repayment was not thought to trigger default of the firm” (pg. 8). We calculated the total equity by adding together the launch aid, RSPs and equity portion from Airbus partner funding.
Also, we ignore the cash flow from pre-payment by airlines when placing orders on the A3XX. WACC Valuation:In order to use WACC model, we need to find out the annual cash flow for the next 20 years and the discount rate that is weighted average cost of capital for the whole project. Since the unlevered beta is known as 0. 84, we can use debt-to-equity ratio of the project to find the levered beta for this investment, which would give us the return on equity of the project (11. 6%).
By looking up historical data on the Internet, we find the yield on long-term corporate bonds (rating A) in June 2000 is 7. 9%. Using these numbers, we calculate the WACC to be 10. 56%. In calculating the cash flow, we use: Price per plane * # of plane sold = RevenueRevenue (1-operating margin rate) = operating margin Operating margin – R&D expense – Depreciation = EBIT *Here depreciation is only counted before 2006, since it would be reflected in operating margin after beginning production. EBIT * (1-T) = EBIAT EBIAT + depreciation – Capital expenditure – increase in working capital = unlevered free cash flow Using these figures r(wacc) equals 10. 56% and we therefore found the NPV of the A3XX investment to be negative $931 million (accounting for the initial cost of $700 million in 2000).
FTE Valuation: Similarly, we use the same EBIT as in the WACC calculation.EBIT – B*rb = taxable income Taxable income *(1-T) = NI NI – Net capital expenditure – net working capital + new debt – debt repayment = free cash flow to equity Using r(s) of 11. 6% as the discounting rate, we get a net present value of negative $2. 7 billion. *In both case, we did not use the company’s estimated rate of growth which is 4.
9%. We thought it would be too big compared to what the number shows. So we decided to use a relatively smaller growth rate (2%), which is close to the inflation rate. Both ways are based on the assumption that the target debt to value ratio is applied to the project over its life.
When using WACC, we do not have to figure out the capital structure of the initial investment (in this case is $700 million), however, we do need to find out the equity and debt amount in the initial investment when using FTE (in the calculation, we just assume the $700 million outlay is entirely equity financed). Comparison and Breakeven After careful analysis of the complex financing Airbus utilized with the A3XX, it is our opinion that Airbus should not proceed with the development due to the fact that the project requires a large and very risky outlay of funds and returns a negative Net Present Value (NPV).But there are some points that should be taken into consideration. First is the operating margin. As we mentioned before, we choose a relatively small operating margin in order to get a conservative estimation.
If we increase this margin, we would get a more positive outcome on both analyses. In exhibit 13, we found there is a positive relationship between NPV (in both methods) and operating margin. Second is the prepaid money from airlines’ ordering the Airbus3XX. It would also increase the total value of the project since we the cash inflow was occur earlier.
Third is identity of launch aid. We treat it as a preferred stock in this case, however, it also have unique characteristic similar to debt. As governments want to support the company, they would require a low rate of return (probably lower than risk-free rate). In that case, weighted average cost of capital rate would decrease, which means the value of the project would ultimately increase. In order to find a way to make our project profitable, we use goal seek to find breakeven points. By making changes to different inputs, we find several ways to get a 0 NPV.
For the WACC method, we can increase debt level to $3. 88 billion to decrease the r(wacc), thus increase the total value of the project. Other ways are to increase the operating margin to 17% or increase the sale price to $260. 56 million for 2008.
For the FTE method, we cannot simply decrease the debt level (since we would then make a negative debt level which is impossible), but we can still make a breakeven estimate by increasing the operating margin to 23%, or by increasing the sale price to $347. 1 for 2008. Finally, we can increase the monthly sales (full capacity), for WACC, 56, and for FTE, 75.
Conclusion In conclusion, although the development of the A3XX would likely capture a large portion of the VLA market and give Airbus a competitive advantage over Boeing, the investment in this project should ultimately be rejected. The risks and uncertainties facing Airbus management far outweigh it potential to gain in market share and financial success.Whether or not there would be sufficient demand for the A3XX was uncertain and forecasts varied greatly between Airbus and Boeing, as well as industry reports. In addition, Boeing’s daring, “bet-the-company” gamble launch of the 747 in 1965 turned out to be very difficult and almost caused the company to fail.
Airbus would likely face similar problems in the launch of their A3XX including paying penalty fees for late deliveries, receiving large cash installments in the future, and most importantly experiencing a shortage of funds while faced with a huge financial obligation to debtors.If the A3XX launch failed, it could force Airbus to exit the industry. Despite the lack of available information in this case, it is clear that the A3XX is a high-risk project both in terms of up-front investments and uncertainty of demand. Exhibit 1 |Data & Assumption |? | |Key Assumption of 2008 |? | |Price per Plane (million) |$225.
0 | |Number of plane in steady state |48 | |Operating margin |15% | Exhibit 2 |General Assumption of 2000 |? | |Inflation |2% | |Tax rate |38% |Exhibit 3 |Required Investment (million) |? | |R&D |$11,000. 00 | |Capital Expenditure |$1,000. 00 | |Working Capital |$1,000.
00 | Exhibit 4 |Discount Rate Assumption |? |Risk-free rate |6% | |Market average Asset beta |0. 84 | |Market Risk Premium |6% | |Airbus forecast annual growth rate |4. 90% | Exhibit 5 Airbus company structure (million) |? |? |? | |in 1999 |BAE |EADS |total | |Debt (Euro) |5122 |5696 |? | |Debt (Dollar) |4888. 949 |5436. 832 |10325. 81 | |Equity (Euro) |11991 |8123 |? | |Equity (Dollars) |11445. 4095 |7753.
4035 |19198. 813 | |Exchange rate (6/30/00) $/euro |0. 9545 | |? | |B/S for original company |? ? |0. 349734902 | Exhibit 6 |Funding Structure (million) |? | |Risk sharing Partner (preferred stock) |3500 | |Government launch aid (preferred stock) |3600 | |Airbus Partner (equity + debt) |5900 | |Debt part |2063. 4 | |Equity part |3836. 56 | |Total debt |2063. 44 | |Total equity |10936.
56 | |Total Asset |13000. 00 | Exhibit 7 Return on debt |7. 90% | |Return on equity |11. 6% | |Levered beta for project |0.
94 | |Project r(wacc) |10. 56% | Levered beta = unlevered beta * (1+(1-T))=0. 84*(1+(1-0. 38))=0. 94 R(s) = Rf + levered beta * market premiumProject R(wacc) = 10. 56% Exhibit 8 |? |2001 |2002 |2003 | |wacc model |? |? |? | |Change wacc |9. 62% |debt |3880.
9 | |Change operating margin |17% | |? | |Price change |260. 56 | |? | |Unit sell |55. 58 | |? | |? | | |? | |FTE model |? |? |? | |Change Rs |8. 0% |debt |-2084 | |Change operating margin |23% | |? | |Price change |347. 11 | |? | |Unit sell |74. 05 |? |? | *Unite sell is based on per month base. Exhibit 13 |Operating margin |15% |18% |21% |24% |27% |30% | |NPV(FTE) |-2718.
2 |-1716. 5 |-714. 8 |286. 9 |1288. 6 |2290.
3 | pic *there is a positive linear relationship between NPV and operating margin.