HBS Case: Investment Analysis and Lockheed Tri Star 1.

[A] The Payback period for this machine would be 7 years. The Net Present Value of this project would be -$945.68. The Internal Rate of Return for this project would be 11.49%. All computations were done in Microsoft Excel: Time Index 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Cash Flow -35000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000

Payback -35000 -30000 -25000 -20000 -15000 10000 5000 0

Payback Period

($945.68) 11.49%

NPV@12% IRR

Rainbow Products should not purchase the machine because it doesn t make sense to invest in this project whether you utilize the IRR method or the NPV method. According to the NPV methodology, the project should be rejected because it has a negative net present value of -$945.68. According to the IRR methodology, the project should be rejected because the IRR is less than the weighted cost of capital. [B] According to the NPV methodology, Rainbow Products should purchase this machine with the service contract because the service contract will produce a yearly cash flow of $4,500 in perpetuity. This makes the Net Present Value of the project equal to $2,500. The computations are as follows: NPV = PV(project) Investment NPV = (CO1/k) CO0 NPV = (4500/.12) 35000 NPV = 37500 35000 NPV = 2500

1

00 $13.514.00 $70.469.[C] According to the NPV methodology. any of the projects would be worthwhile. and (2). (1).91 $2. then the IRR rule may be a good tool for this.00 $67.76 $28.000.00 $70. (4). and (2).000.000.76. I would recommend renting a larger stand because it yields the highest internal rate of return. however the case did not indicate any type of capital constraints. The NPV rule prioritizes the project that produces the most positive net cash flow.00 $23. the rankings for these projects would (4).88 $125.00 $44.825. it would also suggest that the project with the project with the highest IRR should be taken.000.000. The differences in rankings are due to the differences in prioritization of cash flows.08 $34.00 $12.00 $67. The net present value for this option would be $34. According to the NPV rule.000.00 1207.00 28.04)) 35000 NPV = 50000 35000 NPV = 15000 2.000. Using the Net Present Value rule.000.61% Using the Internal Rate of Return rule. The IRR rule suggests that the owner should just rent a larger stand for his business because you would get the most bang for your buck. According to IRR. I would recommend building a new stand. In the event that there were capital constraints. (1).62% 18. (5).825.00 $67. (5).12-. This project would produce the highest positive net present value. which is greater than the NPV s of all the other projects. Though IRR methodology suggests that any projects that have an internal rate of return higher than the discount rate is a worthy project to accept. Rainbow Products should invest in this project because the 20% reinvestment and 4% growth rate will produce a positive Net Present Value of $15.000.000.000. The computations are as follows: NPV = PV(project) Investment NPV = (CO1/k-g) CO0 NPV = (4000/(.000.000.00 $70.000.00 Year 1 Year 2 Year 3 $44.00 $23. Project (1)Add New Window (2)Update Existing Equipment (5)Add New Window & Update Equipment (3)Build New Stand (4)Rent a Larger Stand Investment -$75. 2 .18 $27.21% -$1.00 31. therefore applying a NPV rule would be better because it allows for the business owner to understand which project would produce the most cash flows even after everyone is paid off. however the IRR rule prioritizes the project that produces the highest return relative to an initial investment.000. (3).000.000.00 $44.00 -$50.01% NPV@15% $25.00 IRR 34. Computations done in Microsoft Excel: Note: A fifth option was included because adding a new window and updating existing equipment were 2 projects that were not mutually exclusive.976.00 $14.000.461.000. however the rankings of these projects would be as follows: (3).00 $23.000.000.10% $125.

4.000/11.000 in the present value of expected cash flows from the project.000 + $210. Computations are as followed: NPV = PV(project) Investment NPV = 210000 110000 NPV = 100000 VAI should issue 1.000 shares outstanding = $110 value per share 3 . This amount consists of the $1. This means that the existing shareholders will realize a gain of $10 on their stock prices.000 shares at $110 per share. 1.210.000). The total claim that each share has on assets will be $110 (1.000.210.210.000 shares @ $110 per share = $110.000 current market value of assets and $210.000.000 / 11. then the costs of the project will fall on the new shareholders.000 = $1. The Net Present Value of this project is $100.210.000 required capital $1.000.000. The total claim on assets that all VAI shareholders will have will be $1.000 in assets claimed by shareholders $1. If VAI issues new shares and utilizes the capital raised for this project.

00 $560.Lockheed Tri Star and Capital Budgeting At the planned (210 units) production levels.00 $70. the true value of the Tri Star program was -$584.00 $560.00) ($200.00 $560.00) Revenues ($490.00) ($490.00) ($200.00) ($490.00) ($60.00 $70.00 ($584.00) $140.00) ($490.05 million.05) ($480.00 $560.00) $70.00) $420.00) Units Per Year Cost Per Unit Revenue Per Unit Total Number Sales 35 14 16 210 End of Year 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 Investment ($100.00 ($70.00 $70.00) ($200.00 $420.00) ($490.00) ($550.00) ($200.00 $420.00 $140.00) ($490.00) ($200.00) ($200. Computations done in Microsoft Excel: Time "Index" 0 1 2 3 4 5 6 7 8 9 10 Production Costs Net Cash Flow ($100.00 NPV @ 10% Accounting Profit 4 .

00 $175.00) ($625.00) ($200.00 ($274. Computations were done in Microsoft Excel: Time "Index" 0 1 2 3 4 5 6 7 8 9 10 Production Costs Net Cash Flow ($100.00) ($200.00 $600.00 $800.00 $800.At a break-even production of roughly 300 units.00 $600.00) $200.00 $175.00) ($625.5 16 300 End of Year 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 Investment ($100.00 $800.00) ($200.00) $175.00) ($625.00 ($25.38) $150.00 ($625. The true value of the project at that production level was -$274.00) ($625.00) ($200.00 $200.00) ($200.00) $600.00 $800.00 $175.00) ($625.00) Revenues ($625.00) ($200.00 NPV @ 10% Accounting Profit 5 . Lockheed did not really break even in value terms.00 Units Per Year Cost Per Unit Revenue Per Unit Total Number Sales 50 12.38 million.00) $0.

05 million and an accounting loss of $480 million.67 ($706. the Tri Star program would reach true economic break-even.28 million in wealth. At a production level of 300 units.00) ($200.00) ($200.500 per additional unit produced because of the learning curve.25 a share. Because of this poor decision. the project would result in an economic loss of $584. Lockheed shareholders ultimately lost a total of $754.09 $714.01 $269.67 $1.65) ($765.84 16 388 End of Year 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 Investment ($100.034.99) $269.034.00) Revenues ($765.67 $776.01 $10. A true value analysis shows that at the production level of 210 units.00) ($200. I assumed that there would an incremental cost savings of $7.66666667 11.00) ($200.65) ($765. Given certain circumstances in the case.034.65) ($765.67 $258.5 million per unit.67 $1.00 $776.35 $776.00 $0. Lockheed management overestimated the growth rate of air travel industry.08 Units Per Year Cost Per Unit Revenue Per Unit Total Number Sales Learning Curve Cost Savings per Additional Unit Additional Units 64.84 million.01 $269. the average cost per unit was $12.The sales volume that the Tri Star program would need would be roughly around 388 units.00 NPV @ 10% Accounting Profit 0.67 $1.00) $58. analysts suggested that if Lockheed could produce and sell 500 units. the average cost would have been about $11 million per aircraft.00) ($200. 6 . Time "Index" 0 1 2 3 4 5 6 7 8 9 10 Production Costs Net Cash Flow ($100.00) ($200. In the case. In addition to miscalculating the break-even level of production. This would produce a positive NPV using a opportunity cost of capital of 10%.0075 88 The investment decision made by Lockheed to pursue the Tri Star program was not a reasonable one.65) ($765.67 $1. The average cost per unit would be approximately $11.65) ($765.034.01 $269.65) $258. At a total production level of roughly 388 units. Lockheed shares dropped from $70 per share to $3.

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