The purpose of the report is to examine how the acquiring company, Boeing, will acquire its most significant competitor Lockheed Martin Corporation. This is despite the fact that both companies are competing in the aerospace/defense products and services industry (Yahoo, 2016). Boeing is considered as the largest commercial, defense, space and security manufacturer in the world (Boeing, 2016, p.ii) while Lockheed manufactures products for government agencies under the civil, intelligence, and defense departments (Yahoo, 2016a). The difficulty in this task is that Boeing’s market capitalization is at $84.79 billion, which was only slightly higher than the market capitalization of Lockheed at $72.37 billion (Yahoo, 2016).
Debt Funding
Based on the statement of financial position, the company has a combined short-term and long-term debt value of $9,964 million, while the total shareholder’s equity is at $6,397 million with the non-controlling interest (Boeing, 2016, p.65). This means that the company is using debt as its main source of funding. The debt is mainly composed of unsecured debt securities with only a minimal amount for the non-recourse debt and notes (Boeing, 2016, p.100). The higher interest rate for the unsecured debt is 7.25-8.75%, while the non-recourse debt and notes has a rate of 6.98%-7.38% (Boeing, 2016, p.100).
The most significant debt acquired by the company is the accumulated unsecured debt of $5,075 million due at 2045 with a rate of 0.95%-4.88%, while the lowest debt is $150 million, which is the capital lease obligations due until 2024 (Boeing, 2016, p.100). Note 11 does not indicate an earlier maturity period until 2021 but will require significant principal payments averaging between $1,126-1,248 million at 2016, 2019 and 2020 while a minimal payment of $368 million will be required at 2017 and $703 million in 2018 (Boeing, 2016, p.100).
The examination of the company debt revealed the significant use of unsecured debt, but with a fixed interest rate. The value of using fixed interest rates is it minimizes fluctuations in the interest payments, when variable interest rates are used resulting to reduced volatility in interest costs. Despite the higher interest rate used for the construction in progress, the interest and debt expense decreased due to the lower average debt balances (Boeing, 2016, p.37). This means that management will be able to control and maximize its debt in order to minimize interest costs.
Equity Funding
The examination of note 16 for shareholder’s equity revealed that the company has authorized common and preferred stock, which are 1,200 million shares and 20 million shares respectively (Boeing, 2016, p.113). However item 16 stated that the company did not issue any preferred share (Boeing, 2016, p.113) and thus only common shares are considered to be in circulation. The number of issues common stock remained at 1,012.26 million, which were reacquired and issued as part of the treasury stock (Boeing, 2016, p.113). The examination of the shared table showed that the number of treasury shares is increasing from 256.63 million at the beginning of 2013 to 345.64 million shares by the end of 2015 (Boeing, 2016, p.113).
This means that the company is using its excess income from operations to decrease the number of shares being circulated in the market. But a close examination revealed that the company is also issuing a number of treasury shares during the past three years (Boeing, 2016, p.113), which may be used to fund the company’s operations. This means that the company is maximizing the use of its excess income by decreasing the issued common stock through treasury stock purchases. The value of this strategy is that the company is able to issue current shares in order to generate additional funding for its operations without resorting to the issuance of the preferred shares.
Cost of Debt
The assumptions are that the debt rate used is the highest interest rate of the unsecured debt at 8.75% (Boeing, 2016, p.100) while the effective tax rate for the fiscal year of 2015 is at 27.7% (Boeing, 2016m p.37). The reason for the use of the highest interest rate is that management will prefer to err on the side of the conservative principle in case the company is unable to achieve the minimum required revenue for the year. The average interest rate computed at 5.69% is perceived to be too low since there are other unsecured debt securities and non-recourse debt and notes (Boeing, 2016, p.100) that do not make use of an effective interest rate. The formula used to compute for the after tax cost of debt is included under the weighted average cost of capital (Brealey, Myers, and Allen, 2014, p.221) as seen below with a resulting value of 6.33%.
After-tax Cost of Debt = Rd (1 - Tax Rate)
Cost of Equity Financing
The components required for the computation of the cost of equity using the CAPM formula are the company beta, the market rate of return, and a risk-free rate (Brealey, Myers, and Allen, 2014, p.500).
rs = rRF + (RPm) β
The company beta was taken from the Yahoo Finance website (2016) under the key statistics segment, which is at 1.23. Another beta value taken from the Reuters website (2016) is at 1.07 while Y-chart (2016) computed the company beta as 1.091. In order to comply with the conservatism principle, the beta chosen is the highest value at 1.23, which is taken from the Yahoo Finance website (2016).
The market risk premium is estimated to be between 5-7% as suggested by Berk, DeMarzo, & Harford (2012, p.338) but the rate used in the CAPM is 7%. The risk free rate on the other hand is the latest interest rate of the 20-year treasury bonds (St Louis, 2016). The reason for this treasury bond choice is that the maturity period of most of the company’s current debt is at a minimum of 27 years. The resulting value of 27 years is computed by subtracting the current year of 2016 from the lowest long-term debt period of the unsecured debt securities at 2043 (Boeing, 2016, p.100). The resulting cost of equity using the CAPM model is at 10.82%.
Optimal Capital Structure
Arseneau, Rappoport, and Vardoulakis (2015, p.39) believe that there is no optimal capital structure due to the fact that it does not take into account its effect on the secondary market liquidity. The reason for this is that debt financing is perceived to be more advantageous due to not only the lower cost of repayments but also its ease (Berk, DeMarzo, & Harford, 2012, p.440). This was seen in the availability of additional debt allowed to the company under credit line agreements worth $4,980 million (Boeing, 2016, p.99). The problem with this is that the time period for the repayment is perceived to be limited to only 364 days (Boeing, 2016, p.99).
The current capital structure is 39% of the common stock while it is 61% of the long-term debt. The reason for the higher dependence on debt financing is that the after-tax rate for the borrowings are perceived to be lower at 6.33% when compared to the cost of equity at 10.82%. The additional value of using debt is that the current interest rate acquired by the company during 2015 has a maximum value of 3.5% (Boeing, 2016, p.99) when compared to the annual dividend per share of $3.82 in 2015 (Boeing, 2016, p.32). The resulting effect is a payment of $275 million for the interest and debt expense in 2015 (Boeing, 2016, p.63) when compared to the dividend payment of $2,490 million (Boeing, 2016, p.67).
Based on Yahoo Finance key statistics the total debt/equity value is at 242.67 for Boeing (Yahoo, 2016) while the ratio for Lockheed is at 480.83 (Yahoo, 2016a). The debt value of Lockheed is at $15.28 billion (Yahoo, 2016a), which is higher by 50% more than that of Boeing at 9.96 billion (Yahoo, 2016). However, Boeing was able to achieve net earnings of $5,176 million in the fiscal year of 2015 despite the payment of the interest and debt expense (Boeing, 2016, p.63). Under the assumption that the company’s revenue and profits are retained in the next couple of years, this means that Boeing can acquire 10x the current long-term debt and still easily pay off the interest and a portion of the debt principal. The company can therefore increase its long-term debt by a maximum of 8x its current debt levels, which will result in a 0.07 equity and 0.93 long-term debt.
Weighted Average Cost of Capital
The components of the weighted average cost of capital (WACC) use the computed after-tax cost of debt, the cost of equity using the CAPM, and the percentage of debt and equity (Berk, DeMarzo, & Harford, 2012, p.470). The component values were already computed above and using the original percentage of debt and equity will result in a WACC value of 8.08%. This therefore means that the current cost of financing for the company operations is higher using a pure debt financing approach, but lower when using a pure equity financing approach (Berk, DeMarzo, & Harford, 2012, p.470).
When the assumed optimal capital structure of 7% equity and 93% long-term debt is used the WACC value will decline to only 6.66%. The main advantage of this financing approach is that the company is increasing its tax shields since the higher interest expense will lower the taxable income (Berk, DeMarzo, & Harford, 2012, p.478). But the problem with this financing strategy is the potential for financial distress and bankruptcy since the company is not assured that future revenues and profits will be retained resulting to potential interest payment defaults (Berk, DeMarzo, & Harford, 2012, p.478).
Acquisition Payment Strategy
Boeing also did not fully issue all of its common stock since the outstanding and unused stock held by the company is 187.74 million (Boeing, 2016, p.113), which is worth around $24,988.04 million. The market value of which is based on the last closing price of the BA stock at $133.10 on June 9, 2016 (Yahoo, 2016). If the market value of Lockheed is at $72.37 billion (Yahoo, 2016) then the remaining payment will be in the form of debt financing. The assumption of paying off $72.37 billion is considered to a best case scenario since Boeing will have to assume Lockheed’s current debt of $15.28 billion (Yahoo, 2016a). Boeing will therefore initially use the outstanding and unused 187.74 million shares before resorting to additional debt in order to acquire the Lockheed Company.
Growth Plan
The value of acquiring Lockheed is that its core strength is that it is primarily manufacturing, defense, space and security products for the government. The value of this is that the proprietary technology of Lockheed can be used in the other operating segments of Boeing. The reason for which is that it minimizes research and development costs of Boeing due to the potential cost efficiencies of a downstream supply chain, which is Lockheed. Lockheed’s proprietary technology can be used to benefit allied government customers with regards to space and security products, which will in turn benefit the company and the U.S. government. Potentially dangerous proprietary technology can be retained only for use by the U.S. government. The main benefit for Boeing is that it removes a significant competitor within the industry and therefore can result in an increase in sales price for its products as well as the company profitability.
References
Arseneau, D. M., Rappoport, D. E., and Vardoulakis, A. (2015). Secondary market liquidity and the optimal capital structure. Finance and Economics Discussion Series, p.1-68. Retrieved from http://www.federalreserve.gov/econresdata/feds/2015/files/2015031pap.pdf
Berk, J., DeMarzo, P., & Harford, J. (2012). Fundamentals of corporate finance (2nd ed.). Boston: Prentice Hall.
Boeing Company. (2016). The Boeing Company 2015 annual report. Boeing. Retrieved from http://investors.boeing.com/investors/financial-reports/default.aspx
Reuters. (2016). Boeing Co (BA.N). Reuters. Retrieved from http://www.reuters.com/finance/stocks/overview?symbol=BA.N
St Louis Fed. (2016). 20-Year Treasury Constant Maturity Rate (GS20). St Louis Fed. Retrieved from http://research.stlouisfed.org/fred2/series/GS20/
Yahoo Finance. (2016). The Boeing Company (BA). Yahoo Finance. Retrieved from https://uk.finance.yahoo.com/q?s=BA
Yahoo Finance. (2016a). Lockheed Martin Corporation (LMT). Yahoo Finance. Retrieved from https://uk.finance.yahoo.com/q/pr?s=LMT
Y-Chart. (2016). Boeing (BA). YCharts, Inc. Retrieved from https://ycharts.com/companies/BA/key_stats
Appendix A. Computation of Average Interest Rate
