Lockheed Tri Star and Capital Budgeting Case Analysis

as Presented to:

Professor Raj Gupta

Prepared & Presented By: Christopher Naso Richard Goshgarian Elizabeth Torres Brian Cherry Michael Lee

October19, 2010

SCH-MGMT 640: Financial Analysis and Decisions University of Massachusetts Amherst Isenberg School of Business

which we will examine in detail below.E. more realistic picture of the project’s return. 1 2 Investopedia. Introduction/Motivation Capital investment decisions are long term finance decisions designed to strategically invest in projects that will improve the value of the corporation for stockholders. however if either are used without fully understanding what their prospective results reveal. There are several methods for determining which projects are worth investing in. will show where the mistake happened. We also intend to explain how using the Net Present Value method will uncover a different. but the best methods must take into account the net present value of the future cash flows resulting from the investment using an appropriate discount rate for the project and managements assessment of the risk involved. the management made a decision to proceed with the Tri Star project based on a break-even analysis. “ Journal of Finance 27 (1972. Data/Analysis Section In breaking out the data as referenced in the Harvard Business case study3 from the Lockheed Tri-Star situation. organizing the cash flows in a spreadsheet depiction offered the most clarity in analyzing the information. many organizations use financial methods to determine the viability of projects and decisions based in the initial required investment.com Textbook 3 The Harvard Business case “Lockheed Tri Star and Capital Budgeting” facts and situations were taken from U. In a recent case Lockheed Martin chose to use the Internal Rate of Return to value their Tri Star project. their analysis was flawed. failing to take into account the net present value of their investments resulting in a huge loss of value for the company. mistakes can be made and under-estimations of return will happen. through this case analysis. We have determined this to be a mistake and. As we will show. Reinhardt. and from House and Senate Testimony. with the most commonly used being Internal Rate of Return (IRR) and Net Present Value (NPV). “Break-Even Analysis for Lockheed’s Tri Star: An Application of Financial Theory.Executive Summary Professor Gupta. 821-838. The financial industry has many standards regarding these methods. .12 In the Lockheed case. Each method encompasses positives and negatives.

Analysis at 210 aircraft production Cash flow ($mm) up front costs 0 1 2 3 4 5 6 7 8 9 10 -100 -200 -200 -200 -200 End of year 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 Time "index" unit prod costs deposit revenue remainder -490 -490 -490 -490 -490 -490 140 140 140 140 140 140 420 420 420 420 420 420 Rev-costs NPV @ 10% IRR net flow -100 -200 -200 -60 -550 70 70 70 70 -70 420 -480 ($530. however unit production costs rise a bit to $625mm/year ($12.950. the $900mm in upfront costs remains over the first 6 years. In the scenario where production is assumed @ 300 aircraft for that time period.000. @ 210 aircraft produced over the above time perior. the NPV of the project was $530.44) 2% As seen above.000 when netting the costs of the project with the revenues. In analyzing the cash flows @ 210 aircraft for those 10 years keeping in mind the 10% assumed cost of capital to Lockheed. and revenues are divided up in both 25% deposits ($140mm/yr from 1970-1975) and the balance of those revenues ($420mm/yr from 1972-1977).5mm/aircraft at 50 aircraft/year) as do revenues assuming all built aircraft are sold at that same . annual unit production costs of $490mm are spread over 6 years (1971-1976). the $900mm in up front costs are spread over the first 5 years (1967-1971). and the project lost $480. the IRR of the project was -9%.95) -9% Analysis at 300 aircraft production Cash flow ($mm) up front costs 0 1 2 3 4 5 6 7 8 9 10 -100 -200 -200 -200 -200 End of year 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 Time "index" unit prod costs deposit revenue remainder -625 -625 -625 -625 -625 -625 -3750 200 200 200 200 200 200 -900 1200 Reveues-costs NPV @ 10% IRR 600 600 600 600 600 600 3600 net flow -100 -200 -200 0 -625 175 175 175 175 -25 600 150 ($249.000.

000. it is clear that an excess of 378 units would need to be sold in order to make the net present value of the project come out positive.000. it was assumed that the per unit cost of production would be further reduced to $11. In analyzing the cash flows @ 300 aircraft for those 10 years assuming the same 10% cost of capital.2 ) E of Y nd ear 16 97 16 98 16 99 17 90 17 91 17 92 17 93 17 94 17 95 17 96 17 97 The management’s breakeven analysis determined that 210 units would need to be sold to start making money on the Tri Star project.75 million.000. . if the Net Present Value of the project is used in this analysis as shown above.7 1 5 38 7 77 0 (0 8 .$16mm price/aircraft and in a similar deposit and balance paid scenario.440. At this level of production. the NPV of the project improved but remains negative at $249.Costs NPV @1 % 0 1 . the IRR remains sub par at 2%. However. Analysis of Breakeven S ales Volume Cash Flow ($ mm) Time "Index" up front costs unit prod costs deposit revenue remainder net flow 0 (1 0 0) (1 0 0) 1 (2 0 0) (2 0 0) 2 (2 0 0) (2 0 0) 3 (2 0 0) 22 5 5 2 4 (2 0 0) (7 0 4) 22 5 (6 8 8) 5 (7 0 4) 22 5 76 5 28 6 6 (7 0 4) 22 5 76 5 28 6 7 (7 0 4) 22 5 76 5 28 6 8 (7 0 4) 22 5 76 5 28 6 9 (7 0 4) 76 5 1 6 1 0 76 5 76 5 Production Cost perunit S les Volume a Revenue . but the accounting break even analysis actually shows a small profit of $150.

and IRR of paint-mixing machine.000. i. Ultimately this poor decision resulted in dramatic loss of wealth for the Lockheed shareholders totaling a loss of $757 million in stock value. Rainbow Products—Case Analysis Rainbow Products is considering the purchase of a paint-mixing machine to reduce labor costs. Rainbow should reject this purchase. instead. NPV. B. APPENDIX I. NPV of paint mixing machine including a service contract . In addition.000. CF1-CF15= 5.000) ii. They anticipated a rapid growth in the airline industry that was unsupported by the economic conditions during the 1970s. choose to reinvest some of the productivity savings from the equipment back into the machinery in lieu of service.67 (CFO=-35.49 Conclusion: Based on both the NPV and the IRR of the machine.000 N=15 years i=12% A.Conclusion The investment decision made by Lockheed to proceed with the Tri Star project was not very well thought through.000/$5. Rainbow also has the option to purchase a service contract along with the machine or. Payback. What we know: Annual CF=$5. Here is the analysis of all three scenarios. Even though break even production was calculated to be 210 units. the market conditions were grossly overestimated. IRR=12) iii. a true value analysis shows that this number was much lower than the production actually needed to break even.000 Initial cost=$35. NPV of the machinery is $-945. In addition to simply analyzing the purchase of the machine alone. IRR of the machinery is 11. Payback of the machinery is 7 years ($35.

Using the incremental cash flows for years 1-3 and a discount rate of 15%.000 28. Year Year Year 1 2 3 IRR NPV 44. NPV = $2.46 1 -75.000 Conclusion: Based on NPV. which is a combination of options one and two.000 = -35. Project Add a New Window Update Existing Equipment Add new window & update equipment Using the Internal rate of return (IRR) Optio ns Investm ent .97 3 -125.6 28. C.000 34.000 = -35.00 2 -50.00 34. which is why a fifth option was created.00 13.00 70.00 14.00 67. Concession Stand—Case Analysis For part 2. NPV=$15. you own a concession stand that sells hot dogs. Options one and two are the only two projects that were not mutually exclusive.00 44. popcorn.1% 0 0 0 6 70.000 + 50. There are only three years left on your contract.00 1207. II.00 70.514 0 0 0 67. Four proposals to deal with this issue were devised and are listed below.000 31.000 18.500 Conclusion: Based on the NPV.00 27. peanuts and beer at a ball park.0% 2. Rainbow should reinvest 20% of the cost savings into its machine annually. Any differences between the rankings should be explained.82 4 Build a New Stand -125.6% 0 0 0 2 23. NPV of paint mixing machine and reinvestment of savings in lieu of service contract.00 23.00 44. In addition.00 23. The current stands architecture has restricted sales and profits due the inability to efficiently service long lines.i.500 +37. an additional proposal is listed. i. Rainbow should purchase the machine with the service contract. A recommendation should be based off an analysis using the IRR rule only and then with the NPV rule.47 5 -1.00 67. the IRR and NPV for the respective options were calculated and included in the table.2% 0 0 0 6 Rent a Larger 12.00 25. you must recommend what proposal to take.000 As shown the table.

Differences Between IRR and NPV. The NPV method is better because it prioritized the option that generated the most cash flow as the highest. In the event that there were capital constraints. which is greater than any of the other options. When the discount rate is lower than approximately 18. the NPV of renting a larger stand is higher. the NPV for building a new stand is higher. The IRR method suggested that renting the larger stand should have the highest priority whereas the NPV method suggested that building a new stand did. This is demonstrated in the plot below. Since the discount rate is 15%.Using the internal rate of return rule. . which is better For this case. building a new both was prioritized higher. This proposal yielded the highest IRR.2%.2. renting the larger stand is what we would recommend. The reason for this relates to the timing of cash flows. the IRR suggests that renting the larger stand is better. we would recommend option 4. When the discount rate is greater than approximately 18. which is to build a new stand. including options one and two combined. Using the Net Present Value (NPV) Based off the Net Present Value (NPV) rule. The remainder of the proposals had positive IRR's as well.826. they could very well be worthwhile projects but ranked lower than option 4. the IRR and NPV rules suggest different rankings. making any of them a worthy project to accept. The total cash inflow for building a new stand is greater than the option to rent a larger stand but because it occurs later. The NPV for this option is 34. This suggests that the opportunity costs of capital are less than the internal rate of return. Since the other options also have positive NPV’s. the IRR method may be more appropriate but that information was not presented in this case.

Your firm has 10. You will raise the necessary capital for this investment by issuing new equity. You then discover an opportunity to invest in a new project that produces positive cash flows with a present value of $210. and are willing to pay “fair value” for the new shares of VAI common. Your total initial costs for investing and developing this project are only $110.000 shares of common stock outstanding. . For part IV You are the CEO of Valu-Added Industries.IV. Valu-Added Industries. Inc (VAI) Fiancial information as a result of investment in a Project. (VAI). and the current price of the stock is $100 per share.000. All potential purchasers of your common stock will be fully aware of the project’s value and cost.000. Inc.

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