Analyze How Embraer Has Structured Itself Economics Essay

This paper will focus on the commercial aircraft industry. The report will analyze how Embraer has structured itself and gained competitive advantage in lower end segment of the aircraft industry and then the analysis of cost of capital of Embraer will be projected.

The commercial aircraft industry has faced a tough times in recent past which resulted in failures, mergers and joint ventures. The aircraft industry has faced a lot of competition from two of the giants Boeing and Airbus which have dominated the whole aircraft market and has maximum market share. These two giants have huge pool of investment, better infrastructure and government support and because of that they are dominating the aircraft market. All these companies see the current business environment possessing the challenges of a weak global economy and demand due to the economic turmoil, high and unstable fuel costs, and lack of foreign investments.

Brazil PEST Framework:

Political:

Federal Republic framework which is similar to that of United States of America. The federal republic has three independent branches independent branches: executive legislative and judicial. The President heads the executive branch.

The increasing divergence between US and Brazilian foreign policy creates high geopolitical risk. This will lead to increasing confrontations between the US and Brazil and the continued decline of foreign direct investment.

The main source of violence in Brazil is criminal rather than political. Personal security is poor as there is an extremely high rate of criminal activity in major cities. Police fails to assure safety for citizens as well for business.

Brazilian legal system is not very effective and has several faults in them.

Honest government is also a big problem in Brazil for ex. the impeachment of a former Brazilian president Mello in 1992 who have been involved in an extortion scheme, and the current corruption scandal of the ruling party of Lula.

Inefficient government policies towards economic development of a country for ex. continuous budget deficit, negative net income, high external debt, etc.

Poor and inefficient public health and safety conditions infant mortality and mal-nutrition are the leading reasons.

Inefficient education system both lack of quality and quantity are the main issues and government is not paying much attention towards this issue.

Government regulations favour the minority shareholders.

Government policies towards globalisation and openness to market had favoured exports.

Economic:

Brazil is considered to be as the world’s tenth largest economy and one of the largest economies of South .Its GDP (PPP) per capita is $10,200, putting Brazil in the 105th position in the world. The inflation rate in Brazil is 4.2% which has decreased from 5.9% in 2008. Major export products include aircraft, electrical equipment, automobiles, ethanol, textiles, footwear, iron ore, steel, coffee, orange juice, soybeans and corned beef. The country has been expanding its presence in international financial and commodities markets, and is one of a group of four emerging economies called the BRIC countries.

Economic environment still considered volatile as compared to more stable economies.

Complex tax policies and regulations.

Multiple taxes affecting business plans and increasing risks of contingencies.

Considerable bureaucratic rules and regulations for certain businesses and industries.

High demand for investments in the distribution channels and infrastructure.

Difficulties in reorganizing companies quickly, including high costs for employee terminations.

Lack of local financing coupled with high real interest rates.

Economic growth risks are high. Private consumption will be constrained by high unemployment and continued erosion of real earnings.

The risk of a significant decline in foreign exchange reserves is high because of the economic turmoil.

Investment risk in Brazil is much higher than generally perceived.

High public debt exposed to domestic interest-rate trends and maturity that is still too short

Lack of investment in infrastructure building.

Social:

The culture of Brazil is very much similar to that of Portuguese culture. The official language of Brazil is Portuguese which is spoken by almost all of the population.

Important cultural customs, including a different perception of the due diligence process.

Semi-skilled and unskilled labor in certain developing areas.

Unequal distribution of wealth – a significant portion of the population not participating in the consumer market.

Socio-political obstacles to necessary structural reforms (education, social security, job market, taxes, regulations).

Technological: In Latin America, Brazil is a leading nation in the field of science and technology. Sectors like bio fuels, agricultural research, remote sensing and aircrafts manufacturing Brazil operate as a global leader. Government put more emphasis on the development of research labs and innovation and R&D in these particular sectors to foster growth and development.

Overall Risk Assessment of Brazil:

Positive

Brazil has abundant natural resources.

Fiscal and monetary policy has been prudent and realistic.

Domestic market potential and low labour costs have continued to attract foreign investors.

The current level of growth foster Brazilian companies to be competitive.

Strong international financial support.

Policy of maintaining fundamental macroeconomic equilibrium.

Size and potential of the domestic market.

Broad industrial base and a diversified economy.

Government policies favoured globalisation.

Negative

External financing needs are too great in comparison to currency earnings due to the debt amortisation burden.

Socio-political obstacles to necessary structural reforms (education, social security, job market, taxes, regulations)

Lack of investment in energy, rail, road, port, and airport infrastructure

Exposure to fluctuations in world prices for certain staple commodities.

Economic environment still considered volatile as compared to more stable economies.

Complex tax policies and regulations.

Improper financing regulations.

Commercial Aircraft Industry Analysis:

Embraer is now the world’s third largest aircraft manufacturer they had gained competitive advantage by creating cost- efficient and innovative aircrafts in the lower end segment.

Competitive rivalry among existing players:

The competitiveness in the aircraft industry is very high but the competition is not very fierce because most of the market is shared between Boeing and Airbus and rest is with Embraer and Bombardier.

The aircraft industry is truly a global industry so each of the manufacturers has to think globally.

Barrier to exit is very high because of huge investment and high specialised equipments.

Boeing and Airbus had gain market share from each other using prices, product design, advertising, and direct selling efforts. Due to the intensity of the rivalry among Boeing and Airbus, the profits are shared.

The industry is technically very sound i.e. there is not much differentiation between the players and their products hence, there is much price competition.

Threat of new Entrants:

Enter into aircraft manufacturing market is very tough because it requires huge capital investment and knowledge of technical know-how.

Cost advantages of big players like Boeing and Airbus because they have enormous experience and knowledge about the industry.

These two giants have dominated the entire aircraft industry and they also have strong brand loyalty of their products because they are the best in the business.

They have a proper network of loyal supplier and distributor for their products and long term after sales service contracts.

Threat of substitutes:

No immediate substitutes are present for aircraft manufacturers.

The players and their products in the industry are substitutes of one another.

Bargaining power of Customers:

The bargaining power of customers is relatively low in aircraft industries because most of the buyers in the aircraft industries are government of different countries and some private airlines.

Aircrafts are very expensive commodities and show high in cost when switching aircrafts because of that the bargaining power is low in aircraft industry.

But because of intense competition between Boeing and Airbus the bargaining power of buyers is moderately higher between these two companies otherwise it’s relatively low in terms of industry.

Bargaining power of Supplier:

The aircraft industries is dominated by two big giants Boeing and Airbus and they are such big companies that they have more bargaining power than their suppliers so because of this reason the bargaining power will be low in the aircraft industry.

The aircraft industry needs huge investments and high class technology the forward integration is very low or impossible for the suppliers.

According to this analysis the main components which are needed to compete in aircraft industry are global strategy, cost effectiveness, innovative and high class technology and huge capital.

Core Competencies of Embraer which helps them to compete in Aircraft Industry:

Country Factor: The Brazilian government has had a strong affect on Embraer. As mentioned, the company was founded by the government in 1969. Before its privatization in 1994, Embraer had established several partnerships abroad and was very focused on exporting its aircraft to new markets. The government does have strategic power and has ability to refuse certain decisions.

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Global Strategy: Embraer has proven itself a truly global company in many ways. Embraer has more than 90% of its sales outside Brazil. It has a worldwide operation network. It has appeased global investors because it deals mostly in US dollars. Embraer focuses on business growth, solid corporate culture, and strategic partnership to operate globally and market analysis before entering a new market.

Economies of scale: Embraer is proved to be a very efficient company in the aircraft industries because Embraer recognises that China has skilled cheap labour and technology intensive manufacturing centre so they have opened their research hubs and manufacturing units in China. Embraer has been able to design common platforms for its aircrafts with superior performance capabilities which helped them to compete in the aircraft industry and now they have become the world’s third manufacturers and they have overtook Bombardiers in several aspects.

Innovation: Embraer has focused its R&D on the development, systems engineering and integration of the more than 28,000 parts and components that make up an aircraft. Embraer’s strategy has been to focus its R&D funds on key technologies that it can effectively produce in house. It has outsourced the production of components that other companies can manufacture more efficiently. Embraer trains its engineers, not only in aeronautics, but also in market research and finance, allowing a broader understanding of the industry.

Determined Approach: Embraer has very determined company they are very much determined of what they are doing and that’s why they have succeeded to gain market share from their competitors like Boeing and Airbus.

Embraer’s ability to continually and successfully forecast future global demand and its ability to meet that demand in unique and innovative ways will be the keys to its future success.

Cost of Capital Analysis of Embraer:

“Cost of capital is the minimum required rate of earning or the cut off rate for capital expenditure.”

– Soloman Ezra.

To calculate cost of capital we have to calculate cost of equity and cost of debt.

Cost of Equity:

The minimum rate of return that a firm offers to its shareholders is called cost of equity.

Formula:

Cost of equity = Risk free Rate + Beta (Mature Market Premium) + Country Risk Premium

First to calculate Beta for Embraer:

Average Beta = 1.19

Market D/E Ratio = 22.94%

Tax Rate = 20.05%

Unlevered Beta = 1.00

Cash/ Firm Value = 7.90%

Unlevered Beta corrected for cash = 1.09

To calculate Levered Beta the formula is:

Levered Beta = Unlevered Beta (1 + (1- tax rate) (D/E ratio)

= 1 (1+ (1-.2005) (.2294))

= 1.18.

Risk free Rate = Market Interest Rate – Default Spread (Brazil)

= 8.75 – 2.60

= 6.15%

Equity Risk Premium Brazil = 4.79% * 25.83% / 15.27

= 8.10%

Country Risk Premium Brazil = 8.10% – 4.79%

= 3.31%

Cost of equity = Risk free Rate + Beta (Mature Market Premium) + Country Risk Premium

= 6.15 + 1.18(8.10) + 3.31

= 19.01%

Cost of Debt:

(Rf + credit risk rate)(1-T), where T is the corporate tax rate and Rf is the risk free rate.

Cost of debt Emerging Market company After Tax= Riskless Rate + Country Default Spread + Company Default Spread (1-T)

= (6.15 + 2.25 +2.60) (1- .2005)

= 8.79%

Sovereign Bonds of Brazil = 2.25

Corporate Bonds of Brazil = 2.60

Country Rating of Brazil is Baa3.

WACC Calculation:

The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing:

WACC = E/V * Re + D/V * Rd * (1- T)

Where:

Re = cost of equity

Rd = cost of debt

E = market value of the firm’s equity

D = market value of the firm’s debt

V = E + D

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

T = corporate tax rate = 20.05%

Market Value of Embraer’s Equity = 5970531 Brazilian Real for year 2008.

Market Value of Embraer’s Debt = 6990127 Brazilian Real for year 2008.

V= 12960658 Brazilian Real

WACC = 5970531/12960658 * 19.01 + 6990127/12960658 * 8.79 * (1- .2005)

= 10.71%