COMING UP WITH THE FINANCING DETAILS: BOEING

GETTING TO THE OPTIMAL

APPROACHES FOR EVALUATING ASSET CASH FLOWS

I. Intuitive Approach

Based upon the business that the firm is in, and the types of projects that it takes, arrive at the characteristics that its cash flows are most likely to have ñ
- Are the projects typically long term or short term? What is the cash flow pattern on projects?
- How much growth potential does the firm have relative to current projects?
- How cyclical are the cash flows? What specific factors determine the cash flows on projects?

II. Project Cash Flow Approach

Project cash flows on a typical project for the firm
Do scenario analyses on these cash flows, based upon different macro economic scenarios

III. Historical Data

Operating Cash Flows
Firm Value

COMING UP WITH THE FINANCING DETAILS: BOEING

I. Intuitive Approach

Step 1: Define the typical characteristics for projects taken on by Boeing

Duration: Projects are long term; Boeing 777 project has 30-year life. Defense business is just 8.6% of remaining backlog.

Currency: While Boeing receives 54% of its revenues from overseas, about 75% of its revenues are in dollars. The remaining 25% is in different currencies.

Special features of the Cash Flows:

- Cash flows are correlated with health of the airline business

- Cash flows are generally affected negatively by inflation, since increasing oil prices, in particular, affect the airline business adversely.

- Sales are lumpy; a few large orders (SAS ordering 35 planes) comprise the bulk of revenues, making them sensitive to the financial standing of these companies.

Step 2: Put together a mix of debt that matches up to the assetís cash flow characteristics. This debt would be

- very long term (since the projects are long term)

- fixed term rather than floating rate debt (to increase the duration of the debt, and since cash flows at Boeing are more likely to be adversely affected by inflation than helped by it.)

- be primarily in dollars

It would also be nice if the debt could have some feature that tied payments on the debt to the health of the airline business, increasing when the airline business is doing well and decreasing when the airline business is doing badly.

II. QUANTITATIVE APPROACH

The nature of a firmís cash flows can be examined using one of two variables ñ

1. Operating Cash Flows: The question of how sensitive a firmís asset cash flows are to a variety of factors, such as interest rates, inflation, currency rates and the economy, can be directly tested by regressing changes in the operating income against changes in these variables.

Change in Operating Income_t = a + b Change in Macro Economic Variable_t

The limitation of this approach is that it examines the effect of these factors only on current income.

2. Firm Value: The firm value is clearly a function of the level of operating income, but it also incorporates other factors including expected growth and the cost of capital. To see why, consider the value of a firm, in stable growth ñ

Value of Firm = After-tax Operating Income / (WACC - Expected Growth rate)

Thus, by looking at the changes in firm value, we are capturing the effects of changes in macro economic variables on operating income, expected growth and cost of capital.

Sensitivity to Factors: Past Data

Step 1: Collect past data on firm value, operating income and the macro economic variables against which you want to measure their sensitivity.

Year

Firm Value

Operating Income

Change in Firm Value

Long Bond Rate

Real GNP
Inflation Rate
Weighted Dollar

1980

$ 4,254

$ 877

11.90%

3846

13.50%

99.37

1981

$ 2,182

$ 715

-48.71%

14.20%

3849

10.30%

110.47

1982

$ 3,270

$ 578

49.8%

13.80%

3792

6.10%

123.14

1983

$ 4,254

$ 701

30.1%

12.00%

4047

3.20%

128.65

1984

$ 5,503

$ 725

29.4%

12.70%

4216

4.30%

138.89

1985

$ 8,131

$ 968

47.8%

11.40%

4350

3.50%

125.95

1986

$ 8,179

$ 1,095

0.6%

9.00%

4431

1.90%

112.89

1987

$ 5,889

$ 706

-28.0%

9.40%

4633

3.70%

95.88

1988

$ 9,532

$ 1,018

61.9%

9.70%

4789

4.10%

95.32

1989

$ 13,959

$ 1,217

46.4%

9.30%

4875

4.80%

102.26

1990

$ 15,900

$ 2,208

13.9%

9.30%

4895

5.40%

96.25

1991

$ 17,610

$ 2,785

10.7%

8.80%

4894

4.20%

98.82

1992

$ 15,391

$ 2,988

-12.6%

8.10%

5061

3.00%

104.58

1993

$ 17,324

$ 2,722

12.6%

7.20%

5219

3.00%

105.22

1994

$ 18,624

$ 2,302

7.5%

8.00%

5416

2.60%

98.6

A Compromise when firm value is not available

In cases where the firm value is not available, either because the data is missing or the firm has not been listed long enough, the firm values of comparable firms that have been listed for a longer period can be used in the regression.

Step 2: Estimate the sensitivity of firm values and operating income to changes in the macro economic variables using data over the period.

How sensitive is firm value/operating income to changes in interest rates?

The answer to this question is important because it

it provides a measure of the duration of the firmís projects
it provides insight into whether the firm should be using fixed or floating rate debt.

Results of the Regression

Regressing changes in firm value against changes in interest rates over this period yields the following regression ñ

Change in Firm Value = 0.13 - 9.95 ( Change in Interest Rates)

Conclusion: The duration (interest rate sensitivity) of Boeingís asset values is about 10 years. Consequently, its debt should have atleast as long a duration.

Why is the coefficient in the regression a measure of the duration?

Traditional Duration Measure

The duration of a straight bond or loan issued by a company can be written in terms of the coupons (interest payments) on the bond (loan) and the face value of the bond to be

Holding other factors constant, the duration of a bond will increase with the maturity of the bond, and decrease with the coupon rate on the bond.

Duration of a firm's assets

This measure of duration can be extended to any asset with expected cash flows on it. Thus, the duration of a project or asset can be estimated in terms of the pre-debt operating cash flows on that project.

where,

CF_t = After-tax operating cash flow on the project in year t

Terminal Value = Salvage Value at the end of the project lifetime

N = Life of the project

The duration of any asset provides a measure of the interest rate risk embedded in that asset.

Calculating the Duration of the Boeing 777 Project

Year

Cash Flow

PV of Cash Flow

t * PV of Cash Flow

1

$ (711.12)

$ (634.93)

$ (634.93)

2

$ 1,754.92

$ 1,399.01

$ 2,798.02

3

$ 1,867.92

$ 1,329.55

$ 3,988.65

4

$ 1,625.72

$ 1,033.17

$ 4,132.70

5

$ 1,771.84

$ 1,005.39

$ 5,026.95

6

$ 1,465.56

$ 742.50

$ 4,454.99

7

$ 1,666.36

$ 753.78

$ 5,276.44

8

$ 1,246.92

$ 503.61

$ 4,028.88

9

$ 1,971.60

$ 710.98

$ 6,398.81

10

$ 588.10

$ 189.35

$ 1,893.52

11

$ 1,431.76

$ 411.60

$ 4,527.56

12

$ 1,839.88

$ 472.25

$ 5,667.02

13

$ 825.68

$ 189.22

$ 2,459.92

14

$ 640.73

$ 131.11

$ 1,835.48

15

$ 5,384.56

$ 983.74

$ 14,756.08

Sum =

$ 9,220.33

Duration = $ 66,610 / 9220 = 7.20 years

Results of the Regression

Regressing changes in operating cash flow against changes in interest rates over this period yields the following regression ñ

Change in Operating Income = 0.09 - 7.42 ( Change in Interest Rates)

Conclusion: Boeingís operating income, like its firm value, has been very sensitive to interest rates, which confirms our conclusion to use long term debt.

Generally speaking, the operating cash flows are smoothed out more than the value and hence will exhibit lower duration that the firm value.

B. How sensitive has firm value been to changes in the economy?

The answer to this question is important because

it provides insight into whether the firmís cash flows are cyclical and
whether the cash flows on the firmís debt should be designed to protect against cyclical factors.

If the cash flows and firm value are sensitive to movements in the econ

Year	Firm Value	Operating Income	Change in Firm Value	Long Bond Rate	Real GNP	Inflation Rate	Weighted Dollar
1980	$ 4,254	$ 877		11.90%	3846	13.50%	99.37
1981	$ 2,182	$ 715	-48.71%	14.20%	3849	10.30%	110.47
1982	$ 3,270	$ 578	49.8%	13.80%	3792	6.10%	123.14
1983	$ 4,254	$ 701	30.1%	12.00%	4047	3.20%	128.65
1984	$ 5,503	$ 725	29.4%	12.70%	4216	4.30%	138.89
1985	$ 8,131	$ 968	47.8%	11.40%	4350	3.50%	125.95
1986	$ 8,179	$ 1,095	0.6%	9.00%	4431	1.90%	112.89
1987	$ 5,889	$ 706	-28.0%	9.40%	4633	3.70%	95.88
1988	$ 9,532	$ 1,018	61.9%	9.70%	4789	4.10%	95.32
1989	$ 13,959	$ 1,217	46.4%	9.30%	4875	4.80%	102.26
1990	$ 15,900	$ 2,208	13.9%	9.30%	4895	5.40%	96.25
1991	$ 17,610	$ 2,785	10.7%	8.80%	4894	4.20%	98.82
1992	$ 15,391	$ 2,988	-12.6%	8.10%	5061	3.00%	104.58
1993	$ 17,324	$ 2,722	12.6%	7.20%	5219	3.00%	105.22
1994	$ 18,624	$ 2,302	7.5%	8.00%	5416	2.60%	98.6

Year	Cash Flow	PV of Cash Flow	t PV of Cash Flow*
1	$ (711.12)	$ (634.93)	$ (634.93)
2	$ 1,754.92	$ 1,399.01	$ 2,798.02
3	$ 1,867.92	$ 1,329.55	$ 3,988.65
4	$ 1,625.72	$ 1,033.17	$ 4,132.70
5	$ 1,771.84	$ 1,005.39	$ 5,026.95
6	$ 1,465.56	$ 742.50	$ 4,454.99
7	$ 1,666.36	$ 753.78	$ 5,276.44
8	$ 1,246.92	$ 503.61	$ 4,028.88
9	$ 1,971.60	$ 710.98	$ 6,398.81
10	$ 588.10	$ 189.35	$ 1,893.52
11	$ 1,431.76	$ 411.60	$ 4,527.56
12	$ 1,839.88	$ 472.25	$ 5,667.02
13	$ 825.68	$ 189.22	$ 2,459.92
14	$ 640.73	$ 131.11	$ 1,835.48
15	$ 5,384.56	$ 983.74	$ 14,756.08
	Sum =	$ 9,220.33