Case Study One: Creating Value at General Electric
All commerce is based on projects whether on a grand scale such as the General Electric or on very small scale such as a vendor. The basic idea behind commercial projects is to ensure that the amount of money realized at the end of the project is more than that put into the project (Frank & Shen, 2016). When this happens, there is a return on investment for the investor and the company. However, to have any form of investment, a certain amount of money is necessary. In a small project, the investor may put in personal funds but for grand projects, some form of financing is necessary. How the capital is acquired and the expectations that come with that capital inform part of the cost of capital. How the capital is utilized on the other hand, determines whether or not value will be created for the company.
General Electric is a massive company with many of its projects going into billions of dollars. These projects are, therefore, of a pecuniary scope that is beyond the liquidity of the company. To be able to fund its projects, the company relies on debts, preferred stock, and common equity as a source of funds (Brigham & Houston, 2015) . All these sources comes with a form of cost for capital. Debts mainly come in the form of financing with the company being obliged to pay back the monies, which have been advanced. The cost of capital for a debt if all goes well is the value of interest attached to the debt. On a worst-case scenario where the debt is not paid, the company can lose its credit ratings and any collateral . Preferred stock and common equity are other ways in which shareholders invest in a company. The cost of capital for them lies in the expectation for the investment to grow and draw dividends. If this fails, the company’s stock may lose value.
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Another capital risk comes from what the company is going to do with the funds extended to it. As indicated above, all commercial activity involves projects. However, not all projects succeed but high-risk projects have high returns with low-risk projects having low-risk returns. This creates the need for a careful balance between seeking to make money and straining to remain afloat. It is on this basis that a company like General Electric has many divisions and departments, which have different approaches to project. These divisions take different kinds of risks, which combine to create the company’s weighted average cost of capital (WACC) ( Brigham & Houston, 2015) . Some companies take great risks and bring back high returns while others focus on low risk and high stability.
Failing to take any capital risk is fatal for a company since it cannot run any projects. It has to take capital risks by borrowing from financiers and selling equity. It is incumbent upon the management of a company to ensure that it borrows only as much as it needs and at the best possible terms to minimize this form of capital risk. This careful borrowing is a strategy that General Electric has excelled in. More important than this is what is done with the capital once it is acquired. This entails seeking to invest the capital in a manner that will not inordinately jeopardize the capital, but bring in great returns. It is the ability to accomplish the two capital risks that has resulted in General Electric’s monumental success.
Case Study Two: Competition in the Aircraft Industry: Airbus vs. Boeing
There are many players in the airline industry from Russia to Europe, and even the Americas, but the current major global players are Airbus and Boeing. The two companies are involved in massive projects involving billions of dollars. Some of these projects are simple and straightforward. For example, a leading airline may order tens of planes worth tens of billions to be manufactured over certain duration of time. Unless the company intending to purchase the planes or finance the purchase goes under, this is a sure investment. The sensitive investments happen when the company on its own notion decides to develop a different kind of plane.
In the mid-20 th century, there was a race to create massive jets. This race seemed to have been won by Boeing with their 474. Miffed, Airbus decided to make an even larger plane by investing US$ 16 billion to develop the massive A380 (Brigham & Houston, 2015) . The industry seemed to be going for larger. However, Boeing did not go for big but elected to go for efficiency. It elected to invest US$6 billion to develop the evolutionary 787 Dreamliner. Miffed again, Boeing elected to have a secondary project for the development of the A350 that closely resembles the concept that the Dreamliner is based on at a cost of US$6 billion.
From an analytical perspective, both Boeing and Airbus have no other use for the planes they are developing except to sell them. In the case the planes do not find buyers, then the projects will fail. The companies will lose their investments and based on how they had raised the capital, they will also suffer the consequences relating to capital risks (Frank & Shen, 2016). If the projects succeed, the companies will rake in great profits and acquire a great return on investment for all their shareholders. There is, however, a secondary issue when it comes to Boeing and Airbus; it might not be possible for them to succeed contemporaneously. Airbus has based its greatest investment on sheer size while Boeing has invested on efficiency. Within the next decade or so, one of the investments will have been proven wrong and most probably one of the companies will suffer.
The problem, however, is not based on planning on the part of either Boeing or Airbus. It seems that both companies had done their project planning properly. They had calculated how much investment they would make and how many planes they would need to sell over what duration of time in order for the projects to realize a return on investment and make profits. This was based on the assessment and comparison of cash flows against the investments made. The short-term looked bleak with negative cash flows but the longer term looked great with positive cash flows. However, the two are global players meaning that the customers that buy from Boeing are the same ones that buy from Airbus. Qantas, Qatar Airways Company, or British Airways will buy a few Boeing 787 and a few Airbuses380s and within the next few years, one of the two, either size or efficiency will prove to be more profitable than the other. When they make further purchases down the line, they will prefer either size or efficiency. If they prefer size, Boeing will suffer losses but if they prefer efficiency, the US$ 6 billion can never make up for the US$16 billion that has gone into the A380 and Airbus will suffer. Efficiency and size are textbook example of how cash flows can be affected by external factors such as competition to the detriment of even the best projects. It is perhaps to extenuate this risk that Airbus made a secondary investment into the efficient plane project and Boeing made a modest investment of US$ 6 billion when the company could most definitely afford more.
References
Frank, M. Z., & Shen, T. (2016). Investment and the weighted average cost of capital. Journal of Financial Economics , 119 (2), 300-315
Brigham, E. & Houston, J. (2015). The basics of capital budgeting. Competition in the aircraft industry: Airbus vs. Boeing. In Fundamentals of Financial Management . Boston, MA: Cengage Learning, 2015
Brigham, E. & Houston, J. (2015). The cost of capital. Creating value at GE. . In Fundamentals of Financial Management . Boston, MA: Cengage Learning, 2015
