Financial Challenges

Chapter 11
Aircraft Makers “Bet the Company”

In 1992, executives of Airbus and Boeing discussed whether or not the world’s airlines needed a huge new jumbo jet, and if so, whether the two companies should jointly design and build it. After looking at the same data, Boeing executives decided that the project was too risky and expensive. However, Airbus executives came to the opposite conclusion. Namely, that it was even more risky not to develop the plane.

Boeing decided to work on a $2 billion overhaul of its existing 747 jumbo jet. Airbus built a huge structure for a mock-up of its new four-engine jet, the A-3XX, to show to prospective buyers. Based on their feedback, the A-3XX became the A-380. It will be the world’s largest jetliner when it starts flying in 2006. The new jumbo jet will be about 50 percent larger than the Boeing 747-400. Seating capacity will range from 500 to 700 passengers depending on the plane’s configuration. Airports probably will need to be redesigned to accommodate passengers boarding and exiting from the plane’s two levels, each of which has two aisles. The development cost for the A-380 is more than US$12 billion.

The two strategies are based on two very different visions of the future. Airbus believes that the number of passengers flying between the world’s busiest airports will grow faster than airport capacity, thus increasing demand for a new generation of jumbo jets. Boeing sees a future with more point-to-point flights between smaller cities as passengers seek to bypass congested hubs.

Who is right? The risk for both companies is huge. If Airbus is right, it will steal some of Boeing’s most lucrative customers and significantly boost its market share. If Airbus is wrong, the financial impact will be devastating. If Boeing is right, it will stem its loss of market share to Airbus. However, if Boeing is wrong, Airbus will capture a significant portion of the market for jumbo jets, a segment that Boeing now controls entirely.

Capital investments sometimes take many years to pay off. In this case, the biggest risk facing Airbus is that the market for super-sized jumbo jets will not develop. Instead of more flights to major hub cities, airlines and passengers may prefer more direct city-to-city flights.

Firms need capital budgeting rules to protect themselves against higher risk projects that have a significant probability of turning out worse than expected. Requiring a higher acceptance threshold for riskier projects puts a cushion between the firm and the consequences of a miss in predicting the project’s outcome. This makes failure or loss less likely. Would you expect the discount rates used by each company to evaluate their respective new aircraft investments to differ? Yes, we would. Boeing currently sells jumbo jets, and it is essentially modifying an existing aircraft platform. Its project is unlikely to greatly increase the risk of its existing business. The uncertainty surrounding future cash flows and the technology involved in the Airbus A-380 are much higher than normal. Accordingly, Airbus should use a higher cost of capital. Boeing now controls the entire market for jumbo jets. How would this fact impact the incremental cash flows of both Boeing and Airbus as they evaluate the NPV of a new super-sized jumbo jet? The relevant cash flows in the capital budgeting process are a company’s incremental cash flows. Since Boeing currently sells jumbo jets, it must take into account the potential lost sales on existing jumbo jets. Since Airbus does not currently have a jumbo jet, it does not have to factor in lost sales on existing aircraft.

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