Business finance- Capital Budgeting

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Capital Budgeting and the Boeing Dreamliner Capital budgeting is the process where firms try to decide which investments they should take, which ones add value to the firm. It typically starts with a problem or an idea, and then we try to decide, ‘Does this make sense? Do we have the capabilities to do it?’ How does a firm decide to invest in a new project? James Linck Associate Professor of Finance Terry College of Business University of Georgia Let’s take an example in the aeronautics industry. Boeing decides they need a new plane. They need a new plane because their customers are spending way too much on fuel, so their customers demand a plane that gets much better fuel economy. Scott Hamilton Aeronautics Expert Leeham Company LLC Seattle, Washington The market just tells the manufacturers, really, when it’s time to build a new airplane. For example, right now, in today’s environment, you have all the fuel cost issues, with fuel being 150 dollars a barrel. You have the likes of Southwest Airlines, here in the United States, asking Boeing, ‘We want a new airplane to succeed the 737, but it’s got to have 15-20 percent better fuel operating costs than what have today.’ And you have several other carriers saying the same thing. The 787 is almost a revolutionary plane because it is using composite fuselage components as opposed to your standard tube and metal as they call it. And that means that the Boeing is disposing and just doing away with the aluminum that airplanes have traditionally been made out of almost since the dawn of when they replaced fabric airplanes. How did Boeing decide to go forward with the Dreamliner project? The development costs for any new airplane runs into the billions of dollars. The 787, for example, is probably going to run in excess of 12 billion dollars. Net Present Value What we do is we project out all these development costs, we project out all these manufacturing costs, and we project out all these revenue. And we take the present value of all the revenue, net of the present value of all these costs, and if that is positive, we call that a positive net present value project, and we should take that. It adds value to our investors. What drives value? What is the difference between profit & value? Let’s make sure we understand the difference between profit and value. Profit vs. Value Profit is really a measure of performance over a particular period, say, one year. Value is a measure of the overall impact of the project over the life of the project. So we’re taking all the value of all the profit for, from now until the end of the project, and valuing that in today’s terms, compared to, say, the performance over one period. Cash Flow The accountants’ definition of performance is net income, simply revenue minus expenses. Unfortunately, you can’t pay bills with net income, you can only pay bills with cash. So what we focus on more is cash flow. And that is the cash that you send out the door, compared to the cash that comes in the door. Should Boeing consider past costs when deciding whether or not to go forward with a project? Opportunity Cost An opportunity cost is basically anything that you give up when you take on this project. For example, if Boeing is going to build this high-cost, very fuel efficient plane, they may likely be giving up a low-cost, less fuel efficient plane. With the 787 superseding the 767, that production is going to come to an end. The same thing was true with different versions of the 737, they, what’s now the current 737 Next Generation airplane succeeded what is now called the 737 Classics production, and that ended after the NG went on to service. Sunk Cost The sunk cost is the cost that has already been spent and cannot be recovered. For example, I’m trying to decide today whether to manufacture this new plane. I already spent two million dollars on a feasibility study to see if it was even possible to make this plane. That two million dollars is not relevant for this decision; it’s a sunk cost. There are, there are examples where the manufacturers have, have invested a lot of research and development money, and they have decided to call it quits before they go into production because it just isn’t the right airplane at the right time. And a perfect example of that is when Boeing looked at the Sonic Cruiser prior to 9/11. The idea behind the Sonic Cruiser was that it would be just about a supersonic airplane, about Mach .95. And Boeing put a lot of research and development into that airplane, but, particularly after 9/11, the airlines came back and said, ‘We want economy. We don’t want speed.’ What effect do delays have on Net Present Value? And it is a big market, it—over a twenty year period, which is what the manufacturers forecast, is predicted to be five or six thousand airplanes, all in. Right now, before the first 787 enters service— which it was actually supposed to do in May of ’08—Boeing has 900 orders for that airplane. It’s the biggest launch of any airplane ever. So let’s say they develop, they develop, they develop, they promised it to customers, and three years into this development cycle, and they’re not going to make it. They’re a couple years behind. What does that do to Boeing? Well, certainly it increases the costs. It increases the costs because they’ve now pushed the revenue back a couple years. Is it going to bankrupt the company? Maybe not. Maybe they planned for this kind of contingency. Maybe they need to get some additional capital from some source. And maybe they’ve just reduced the overall value. But keep in mind, all the money that they’ve spent to that date is a sunk cost already. Everything that they’ve done to that date and spent is no longer relevant to the decision if we should continue forward with this project. From, from the point of the, really the start of the R&D until the entry into service, the EIS, is typically seven years. Boeing tried to do it in five years with the Dreamliner. They have a 15-18 month delay; it’s going to wind up being seven years. So in a nutshell, the capital budgeting process is just constantly evaluating the present value of all the benefits of some particular idea or investment opportunity relative to its cost, on a continuous basis, ignoring the cost that you’ve already spent and cannot recover, but including all incremental costs that are going to happen going forward if you make this investment. Images and video courtesy of © The Boeing Company 1. What is the objective of capital budgeting? 2. Boeing has decided that the Dreamliner has a positive NPV. How does this decision affect shareholder value? 3. How does Boeing account for uncertainties (risks) inherent in the cash flow forecasts for the Dreamliner project?
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