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 (IRR) 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. [B] 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 machine 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 ($1,000) 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:

V=

C kg

2. Suppose you own a concession stand that sells hot dogs, peanuts, popcorn, and beer at a ball park. You have three years left on the contract with the ball park, and 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. 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. The fourth 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 are net of lease payments. You have decided that a 15% discount rate is appropriate for this type of investment. The incremental cash flows associated with each of the proposals are:
Incremental Cash Flows Project Add a New Window Update Existing Equipment Build a New Stand Rent a Larger Stand Investment -$75,000 -50,000 -125,000 -1,000 Year 1 44,000 23,000 70,000 12,000 Year 2 44,000 23,000 70,000 13,000 Year 3 44,000 23,000 70,000 14,000

Using the internal rate of return rule (IRR), which proposal(s) do you recommend? Using the net present value rule (NPV), which proposal(s) do you recommend? How do you explain any differences between the IRR and NPV rankings? 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 MBATs proposed plant are: Year 0 - 1,000,000 Year 1 371,739 Year 2 371,739 Year 3 371,739 Year 4 371,739

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: [A] [B] [C] [D] Subsidize the project to bring its IRR to 25%. Subsidize the project to provide a two-year payback. Subsidize the project to provide an NPV of $75,000 when cash flows are discounted at 20%. Subsidize the project to provide an accounting rate of return (ARR) of 40%. This is defined as:

Average Annual Cash Flow ARR = Investment 2

Investment # of Years

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 subsidy plans would you recommend to the city if the appropriate discount rate is 20%?

4. You are the CEO of Valu-Added Industries, Inc. (VAI). 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: VAI Market Value Balance Sheet Assets $1,000,000 Equity $1,000,000

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 initial costs for investing 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 of the projects 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 issued (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, if any?

Lockheed Tri Star and Capital Budgeting1

In 1971, the American firm Lockheed found itself in Congressional hearings seeking a $250million federal guarantee to secure 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-300B 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 doomed to financial failure from the very beginning.

1 Facts and situations concerning the Lockheed Tri Star program are taken from U. E. Reinhardt, "Break-Even

Analysis for Lockheed's Tri Star: An Application of Financial Theory," Journal of Finance 27 (1972), 821-838, and from House and Senate testimony.

The debate over the viability of the program centered on estimated break-even sales the number of jets that would need to be sold for total revenue to cover all accumulated costs. Lockheeds 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 $800 million and $1 billion. A reasonable approximation of these cash outflows would be $900 million, occurring as follows: End of Year 1967 1968 1969 1970 1971 Time Index t=0 t=1 t=2 t=3 t=4 Cash Flow ($mm) -$100 -$200 -$200 -$200 -$200

According to Lockheed testimony, 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 unit production cost2 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) annual 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 received for the L-1011 Tri Star was about $16 million per aircraft. These revenue flows would be characterized by a lag of a year to the production cost outflows; annual revenues of $560 million can be assumed to occur in six equal increments at the end of years 1972-1977 (t=5 through t=10). Inflation-escalation terms 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 onequarter 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 million 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, $140 million of the $560 million in total annual revenue is actually received as a cash flow two years earlier.

2 Excluding preproduction cost allocations. That is, the $14 million cost figure is totally separate from the $900

million of preproduction costs shown in the table above.

Discount Rate
Experts estimated that the cost of capital applicable to Lockheeds 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 projects 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.3 Industry analysts had predicted this (actually, they had estimated 300 units to be the break-even volume) even prior to the Congressional hearings.4 Based on a learning curve effect, production costs at these levels would average only about $12.5 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 market 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 Stars actual sales performance never approached Lockheeds high expectations. Lockheeds share price plummeted from a high of about $70 to around $3 during this period. There were about 11.3 million shares of Lockheed common outstanding during this period. Exhibit 1 contains additional information on Lockheeds common stock.

Value Added?
As concerns the economic viability of the Tri Star program, there are several interesting points to consider:5

At planned (210 units) production levels, what was the true value of the Tri Star program? At a break-even production of roughly 300 units, did Lockheed really break even in value terms? At what sales volume did the Tri Star program reach true economic (as opposed to accounting) break-even? Was the decision to pursue the Tri Star program a reasonable one? What were the effects of this project on Lockheed shareholders?

3 Time (August 21, 1972), 62. 4 Mitchell Gordon, "Hitched to the Tri StarDisaster at Lockheed Would Cut a Wide Swathe," Barron's (March

15, 1971), 5-14.

5 Ignore taxes and depreciation tax shields here. In cases near the "break-even" volume, these would tend to

offset each other nearly completely.

LOCKHEED, INC. COMMON STOCK

$80 $70 $60 $50 $40 $30 $20 $10 $0 $71 Monthly Prices, 1967-1973

Dollar Price of a Share of Common

$3.25 Jan 67 Jan 68 Jan 69 Jan 70 Jan 71 Jan 72 Jan 73 Jan 74