Harvard Business School 9-291-031 Rev. Novernber 17,1993 Investment Analysis and Lockheed Tri Star 1. Rainbow Products is considering the purchase of a paint-mixing machine to reduce labor costs. ‘The savings are expected. to result in additional cash flows to Rainbow of $5,000 per year. The machine costs $35,000 and is expected to last for 15 years, Rainbow has determined that the cost of capital for such an investment is 12%. [A] Compute the payback, net present value (NPV), and internal rate of return (LRR) for this machine. Should Rainbow purchase it? Assume that all cash flows (except the initial purchase) occur at the end of the year, and do not consider taxes. {bB) For a $500 per year additional expenditure, Rainbow can get a “Good As New” service contract that essentially keeps the machine in new condition forever. Net of the cost of the service contract, the machine would. then produce cash flows of $4,500 per year in perpetuity. Should Rainbow Products purchase the machine with the service contract? [C]___ Instead of the service contract, Rainbow engineers have devised a different option to preserve and actually enhance the capability of the machine over time. By reinvesting 20% of the annual cost savings back into new machize parts the engineers can increase the cost savings at a 4% annual rate. For example, at the end of year one, 20% of the $5,000 cost savings (61,000) is reinvested in the machine; the net cash flow is thus $4,000. Next year, the cash flow from cost savings grows by'4% to $5,200 gross, or $4,160 net, of the 20% reinvestment. As long as the 20% reinvestment continues, the cash flows continue to grow at 4% in perpetuity. What should Rainbow Products do? HINT: ‘The formula for the present value (V) of an initial end-of-year perpetuity payout of $C (growing at g%) per period, with a discount rate of k%, is Professor Miva E. Edleon prepared this case as te bss for class lise rssion ruther than fo llustnt eter effete or inefective haalling of am administrative situation. Portions of this vise ave tusel on an carer case, “Interest Rate Exercises" [IBS No, 289-050 by Prafessor Richard Ruck Copyright © 1991 by the President and Fellows of Harvard Colles. To order capies o¢ request permission to reproduce materials, call |-800-545-7685, write Harvard Business Seliool Publishing, Boston, MA 02163, ot go t bittp:/ /wow hbsp-harvard.edu. No part of this publication may be reprextuced, stored in a retrieval systens, used in a spreadsheet, or transmitted in any form or by any means-electronic, mechanical, photocopying, recording, or otherwise—wvithout the permission of iarvard Business School21-031 Investment Analysts ania Lockie F Suppose you own a concession stand that sells hot dogs, peanuts, popcom, and beer at a ball park Sou have three years left on the contract with the ball park, anc you do not expect it to be renewed. Long lines limit sales and profits. You have developed four different proposals to'reduce the lines and increase profits wt? The first proposal is to renovate by adding another window. The second is to update the equipment at the existing windows, These two renovation projects are not mutually exclusive; you could take both projects. ‘The third and fourth proposals involve abandoning, the existing stand, The third proposal is to build a new stand. ‘Thefgurth proposal is to rent a larger stand in the ball park. ‘This option would involve $1,000 in up-front investment for new signs and equipment installation; the incremental cash flows shown in later years ard¥wet of lease payments You have decided that a 15% discount rate is appropriate for this type of investment, The incremental cash flows associated with wach of the proposals are incremental Cash Flows Pest "Ttrvcsmment [Year [wear [years wa Now Window “376000 400548900 ae 600 UpeateExising Eqdpment "50000 23000-23000 23000 Bui Now San 25900 79000-70900 HO ent Larger San 1000 12.000" __13000__ 14000 © Using te internat rate of return rule (IRR), tohich proposal(s) da you recommend? © Using the net presont outue rule (NPV, which proposal(s) do you recommend? + How do you explain any differences between the IRR and NPV raakings? Which rule is better? 3. MBATech, Inc, is negotiating with the mayor of Bean City to start a manufacturing plant in an abandoned building. The cash flows for MBAT’s proposed plant are: Year0 Year 1 Year2 Year3 Year 4. 7,000,000 371,739 371,739 31739 391,739 The city has agreed to subsidize MBAT. The form and timing of the subsidy have not been determined, and depend on which investment criterion is used by MBAT. In preliminary discussions, MBAT suggested four alternatives: JA] Subsidize the peoject to bring its IRR to 25%, {B}— Subsidize the project to provide a two-year payback, [Ci Subsidize the project to provide an NPV of $75,000 when cash flows are discounted at 20%, [D]_ Subsidize the project to provide an accounting rate of return (ARR) of 40%. This is defined as: j arInvestment Analysis and Lockheed Tri Star 2atoat Average Annual Cash Flow — Gane ARR = ———————_—_——— Investment + 2 You have been hired by Bean City to recommend a subsidy that minimizes the costs to the city. Subsidy payments need not occur right away; they may be scheduled in later years if appropriate. Please indicate how much of a subsidy you would recommend for each year under each alternative suggested by MBAT. Which of the four subst plans would you recommend tothe city ifthe appropriate discount rae is 20%7 4, You are the CEO of Valu-Added Industries, Inc. (VAD. Your firm has 10,000 shares of common stock outstanding, and the current price of the stock is $100 per share, There is no debt; thus, the “market value” balance sheet of VAI looks like: = sumone w00 ‘You then discover an opportunity to invest in a new project that produces positive cash flows with a present value of $210,000. Your total intial costs for iwvesting and developing this project are only $110,000. You will raise the necessary capital for this investment by issuing new equity. All potential purchasers of your common stock will be fully aware ofthe project's value and cost, and are ‘willing to pay “fair value” for the new shares of VAI common. ¢ What is the Net Present Value of this project? © How many shares of common stock must be issuat (at what price) to raise the required capital? © What is the effect of this new project on the value of the stock of the existing shareholders, ifany? Lockheed Tri Star and Capital Budgeting’ In 1971, the American firm Lockheed found itself in Congressional hearings seeking a $250- million federal guarantee to sects bank credit required for the completion of the L-1011 Tri Star program. The L-1011 Tri Star Airbus is a wide-bodied commercial jet aircraft with a capacity of up to 400 passengers, competing with the DC-10 trijet and the A-3008 airbus, Spokesmen for Lockheed claimed that the Tri Star program was economically sound and that their problem was merely a liquidity crisis caused by some unrelated military contracts. Opposing the guarantee, other parties argued that the Tri Star program had been economically unsound and sfoomed to Financial failure fromm the very beginning, | Facts and situations conceming the Lockheed Tri Stee program are taken from U. E. Reinhart, "Broak-Even, Analysis for Lockheed's TriStar: An Application of Financial Theory,” Jouraal of Finaner 27 (1972), 821-838, ancl from Flouse and Senate testimony,2at081 Investment Analysis and Lackheed TH Star The debate over the viability of the program centered on estimated “break-even sales”bthe number of jets that would need to be sold for total revenue to cover all accumulated costs. Lockheed’s CEO, in his July 1971 testimony before Congress, asserted that this break-even point ‘would be reached at sales somewhere between 195 and 205 aircraft. At this point, Lockheed had secured only 103 firm orders plus 75 options-to-buy, but they testified that sales would eventually ‘exceed the break-even point and that the project would thus become “a commercially viable endeavor.” Costs ‘The preproduction phases of the Tri Star project began at the end of 1967 and lasted four years, after running about six months behind schedule. Various estimates of the up-front costs ranged between $820 million and $1 billion. reasonable approximation of these cash outflows would be $900 million, occurting as follows: End of Year Time “Index” Cash Flows (mm) 1967 0 -$100 1968 ter -$200 1969 2 -s200 1970 3 -$200 971 tt 5200 ‘According to Lockheed ‘estimony, the production phase was to run from the end of 1971 to the end of 1977, with about 210 Tri Stars as the planned output. At that production rate, the average anit production cost? would be about $14 million per aircraft. The inventory-intensive production costs would be relatively front-loaded, so that the $490 million ($14 million per plane, 35 planes per -year) annua! production costs can be assumed to occur in six equal increments at the end of years 1971-1976 (t=4 through t=9). Revenues In 1968, the expected price to be regvived for the L-1011 Txi Star was about $16 million per aircraft. These revenue flows would be ciMiracterized by a lag of a year to the production cost ‘outflows; annual revenues of $560 million can be assumed fo occur in six equal increments at the end of years 1972-1977 (t=5 through t=10). Inflation-escalation term in the contracts ensured that any future inflation-based cost and revenue increases offset each other nearly exactly, thus providing no incremental net cash flows. Deposits toward future deliveries were received from Lockheed customers. Roughly one- quarter of the price of the aircraft was actually received two years early. For example, for a single Tri Star delivered at the end of 1972, $4 million of the price is received at the end of 1970, leaving $12 rillion of the $16 million price as cash flow at the end of 1972. So, for the 35 planes built (and presumably, sold) in a year, SH40 million of the $560 million in total annual revenue is actually received as 2 cash flow tivo years earlier. 2 Excluding preproduction cost allocations. That is, the $14 million cost figure is totally separate from the $900 nillion of preproduction costs shown in the table above, a ama‘yestment Analysis and Lockheed Trl Star ree Discount Rate Experts estimated that the cost of capital applicable to Lockheed’s assets (prior to Tri Star) ‘Was in the 9%-10% range. Since the Tri Star project was quite a bit riskier (by any measure) than the typical Lockheed operation, the appropriate discount rate was almost certainly higher than that Using 10% should give a reasonable (although possibly generous) estimate of the project's value, Break-Even Revisited In an August 1972 Time magazine article, Lockheed (after receiving government loan guarantees) revised its break-even sales volume: “{Lockheed} claims that it can get back its development costs [about $960 million] and start making a profit by selling 275 Tri Stars." Industry analysts had predicted this (actually, they had estimated 300 units to be the break-even volume) even prior to the Congressional hearings. Based on a “learning curve” effect, ptoduction costs at these levels would average only about $125 million per unit, instead of $14 million as above. Had Lockheed been able to produce and sell as many as 500 aircraft, this average cost figure may have been even as low as $11 million per aircraft. Lockheed had testified that it had originally hoped to capture 35%-40% of the total free-world marie! of 775 wide bodies over the next decade (270-310 aircraft). This market estimate had been based on a wildly optimistic assumption of 10% annual growth in air travel; at a more realistic 5% growth rate, the total world market would have been only 323 aircraft. The Tri Star’s actual sales performance never approached Lockheed's high expectations. Lockheed’s share price plummeted from a high of about $70 to around $3 during this period. There were about 11.3 million shares of Loctheed common outstanding during this period. Exhibit 1 contains additional information on Lodiheed’s common stock, Value Added? ‘As concems the economic viability of the Tri Star program, there are several interesting posts to consider © At planned (210 units) production levels, what was the true value of the Tri Star progrant? © Ata “break-even” production of roughly 300 waits, did Lockheed really break even in value terms? © At what sales volume did the Tri Star program reach trye economic (as opposed t0 accounting) break-even? © Was the decision to pursue the Tri Star programa reasonable one? What aere the effets of this “project” on Lockheed shareholders? xe(August 21, 1972), 62. 4 Nlitchetl Gordon, "Hitched to the Tri 57,514. STapore taxes and depreciation tax shields hers, In eases near the "break-even" volume, these would tend to uitsteach other nearly completely, lar =Disaster at Lockheed Would Cut a Wide Swathe,” W's (March sai201031 Investment Analysis and Lockneeu 111 ur LOCKHEED, INC. COMMON STOCK ( Monthiy Prices, 1967-1973 470 [ { 460 + $50 $40 fF | $30 f 5 é § 8 5 8 8 5 8 5 & 520 | vol: ee Jon’67 jon '6B J