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01 CORPORATE FINANCE

Group 06

ABHISHEK DIXIT (VLMP/11/01)

ALOK MISHRA (VLMP/11/02)

ANJALI SAHI (VLMP/11/05)

GOURAV (VLMP/11/12)

RAJAT GUPTA (VLMP/11/30)

1

CASE ANALYSIS - INVESTMENT ANALYSIS AND LOCKHEED TRISTAR

1. RAINBOW PRODUCTS:

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?

Solution:

With the current discount rate of 12%,

Considering the PV of the cash flows --

Payback period = 16.17 years, which implies that the purchase shall not be economical at current discount

rate

Investment

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

in M/c

-35000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000

4464 3986 3559 3178 2837 2533 2262 2019 1803 1610 1437 1283 1146 1023 913

NPV = $ -945.68

Rainbow Products should not purchase the paint mixing m/c as the investment is not economical

with (-)ve NPV and IRR less than discounted rate.

b. For a $500 per year additional expenditure, Rainbow can get 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 $4500 per year in perpetuity. Should Rainbow products purchase the

machine with the service contract?

Solution:

Investment in

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

M/c

-35000 4500 4500 4500 4500 4500 4500 4500 4500 4500 4500 4500 4500 4500 4500 4500

4018 3587 3203 2860 2553 2280 2036 1817 1623 1449 1294 1155 1031 921 822

. till infinity

Cash Flow decreases to (5000-500) = 4500$ every year and continues as perpetuity

PV of perpetuity = 4500/0.12 = $37500

NPV = (37500 - 35000) = $2500

IRR = 4000/35000 = 12.86%, which is more than the cost of

Rainbow Products should purchase the paint mixing m/c with the above plan as the investment is a

favorable proposition with (+)ve NPV and IRR more than discounted rate.

ASSIGNMENT 01 ABHISHEK DIXIT, ALOK MISHRA, ANJALI SAHU, GOURAV GARG, RAJAT GUPTA

2

CASE ANALYSIS - INVESTMENT ANALYSIS AND LOCKHEED TRISTAR

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 $5000 cost savings ($1000) is reinvested in the machine; the net cash flow is

thus $4000. Next year, the cash flow from cost savings grows by 4% to $5200 gross, or 4160 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?

Solution:

Investment

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

in M/c

-35000 5000 5200 5408 5624 5849 6083 6327 6580 6843 7117 7401 7697 8005 8325 8658

Outflow % 20% 20% 20% 20% 20% 20% 20% 20% 20% 20% 20% 20% 20% 20% 20%

Outflow

1000 1040 1082 1125 1170 1217 1265 1316 1369 1423 1480 1539 1601 1665 1732

Amount

Net Cash

4000 4160 4326 4499 4679 4867 5061 5264 5474 5693 5921 6158 6404 6660 6927

Flow

PV of Cash

3571 3316 3079 2859 2655 2466 2289 2126 1974 1833 1702 1581 1468 1363 1265

Flow

till infinity

NPV = -35000+50000 = $15000

Rainbow Products should purchase the paint mixing m/c with the above scenario as the investment

is a favorable proposition with (+)ve NPV and IRR more than discounted rate.

d. Using the internal rate of return rule (IRR), which proposal(s) do you recommend?

Solution:

Project Investment Year 01 Year 02 Year 03 IRR

Add a new window -75000 44000 44000 44000 34.62%

15% - PV 38261 33270 28931

Update Existing Equipment -50000 23000 23000 23000 18.01%

15% - PV 20000 17391 15123

Build a new stand -125000 70000 70000 70000 31.21%

15% - PV 60870 52930 46026

Rent a larger stand -1000 12000 13000 14000 1207.61%

15% - PV 10435 9830 9205

Proposal Project 4

ASSIGNMENT 01 ABHISHEK DIXIT, ALOK MISHRA, ANJALI SAHU, GOURAV GARG, RAJAT GUPTA

3

CASE ANALYSIS - INVESTMENT ANALYSIS AND LOCKHEED TRISTAR

e. Using the net present value rule (NPV), which proposal(s) do you recommend?

Solution:

Incremental Cash Flow

Project Investment Year 01 Year 02 Year 03 NPV

Add a new window -75000 44000 44000 44000 25,462

15% - PV 38261 33270 28931

Update Existing Equipment -50000 23000 23000 23000 2,514

15% - PV 20000 17391 15123

Build a new stand -125000 70000 70000 70000 34,826

15% - PV 60870 52930 46026

Rent a larger stand -1000 12000 13000 14000 28,470

15% - PV 10435 9830 9205

Proposal Project 3

Project 3 is proposed for investment as the absolute return based on scale of investment as the

present value estimated is on a higher side.

f. Which rule should we use? Why?

Solution:

NPV Rule shall be chosen.

We shall choose Project 03 on overall basis as NPV is more relevant and justifiable tool when compared to

IRR and the basic reasons are as follows -

a) IRR rule is misleading due to difference in size of investment.

b) The difference in ranking is explained by the size of investment

c) NPV interprets the absolute return in terms of present value indicating the size of the investment as

well which is not reciprocated in the IRR rule.

d) Using NPV rule, we recommend "Build a new stand".

3. LOCKHEED TRISTAR:

g. Provide cash flows and NPV analysis for the Tri star program at planned production level of 210 units?

Solution:

Herein, we consider year 1967 as base yr. & discount rate 10% constantly, carrying out calculations as -

Units: 210, Cost price = $14 million / unit, Sales price = $16 million / unit

Discount Rate 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%

t= 0 1 2 3 4 5 6 7 8 9 10

Year/Timeline 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 Total

Pre-production cash

-100 -200 -200 -200 -200 -900

outflow (A)

Production Cash

-490 -490 -490 -490 -490 -490 -2940

Outflows (B)

Cash Inflow in

140 140 140 140 140 140 840

Advance (C)

Cash Inflow as after

420 420 420 420 420 420 2520

sales (D)

Cash Flow -100 -200 -200 -60 -550 70 70 70 70 -70 420 -480

PV of Cash Flow -100 -182 -165 -45 -376 43 40 36 33 -30 162 -584

ASSIGNMENT 01 ABHISHEK DIXIT, ALOK MISHRA, ANJALI SAHU, GOURAV GARG, RAJAT GUPTA

4

CASE ANALYSIS - INVESTMENT ANALYSIS AND LOCKHEED TRISTAR

Net Cash Flow = - $480 million

NPV = - $584 million

IRR = - 9.09%

h. Provide cash flows and NPV analysis for the Tri star program if 300 units were sold over a 6 year production

period?

Solution:

Herein, we consider year 1967 as the base year and henceforth carry out entire base of calculation

Units: 300, Cost price = $12.5 million / unit, Sales price = $16 million / unit

Discount Rate 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%

t= 0 1 2 3 4 5 6 7 8 9 10

Year/Timeline 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 Total

Pre-production cash

-100 -200 -200 -200 -200 -900

outflow (A)

Production Cash

-625 -625 -625 -625 -625 -625 -3750

Outflows (B)

Cash Inflow in

200 200 200 200 200 200 1200

Advance (C)

Cash Inflow as after

600 600 600 600 600 600 3600

sales (D)

Cash Flow -100 -200 -200 0 -625 175 175 175 175 -25 600 150

PV of Cash Flow -100 -182 -165 0 -427 109 99 90 82 -11 231 -274

NPV = - $274 million

IRR = 2.38%

i. How did decision to pursue Tri star program affect shareholder value?

Solution:

The Tri star program as evident from the data above was a disaster as the absolute returns are negative

even after consideration of sales of 300 units of commercial aircrafts. This led to plummeting shares price,

which can be calculated as follows:

Share price (per unit) by end of 1967 = $70

Share price (per unit) in Jan 1974 = $3

Outstanding shares during the period = 11.39 million units

Total decline in shareholders value = (70-3)*11.3 = $797.3 million (approx.)

j. Should Lockheed have continued the Tri star program at the end of 1970?

Solution:

The Tri star program was based primarily on the estimates of wildly optimistic assumption of 10% growth

(over a decade) in air travel leading to demand of around 775 aircrafts and Tri Star estimated a market share

of 35-40% i.e. around 270-310 aircrafts. However, the realistic growth rate was only 5% with demand (over

a decade) of only around 323 aircrafts which @ 35-40% shall results in market share (most optimistic) of

40% which comes to around 132 aircrafts (129 aircrafts considered as 132 for ease of calculation) i.e. 22

aircrafts over a period of 6 years.

ASSIGNMENT 01 ABHISHEK DIXIT, ALOK MISHRA, ANJALI SAHU, GOURAV GARG, RAJAT GUPTA

5

CASE ANALYSIS - INVESTMENT ANALYSIS AND LOCKHEED TRISTAR

The calculation when translated over a period of 10 years commencing 1967, we find that both the Cash

flows and NPV, IRR are negative for the said period.

Units: 132, Cost price = $14 million / unit, Sales price = $16 million / unit

Discount Rate 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%

t= 0 1 2 3 4 5 6 7 8 9 10

Year/Timeline 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 Total

Pre-production cash

-100 -200 -200 -200 -200 -900

outflow (A)

Production Cash

-308 -308 -308 -308 -308 -308 -1848

Outflows (B)

Cash Inflow in

88 88 88 88 88 88 528

Advance (C)

Cash Inflow as after

264 264 264 264 264 264 1584

sales (D)

Cash Flow -100 -200 -200 -112 -420 44 44 44 44 -44 264 -636

PV of Cash Flow -100 -182 -165 -84 -287 27 25 23 21 -19 102 -640

NPV = - $640 million

IRR = -14.44%

Again, if we consider that Lockheed Tri Star sells 210 units of aircrafts such that Cost = $14 million per unit

and Selling price of $16 million per unit, then on analysis of the initial 4 years yields -

t= 0 1 2 3

Year/Timeline 1967 1968 1969 1970 Total

Pre-production cash outflow (A) -100 -200 -200 -200 -700

Production Cash Outflows (B) 0

Cash Inflow in Advance (C) 0

Cash Inflow as after sales (D) 0

PV of Cash Flow -100 -182 -165 -150 -597

At the start of the year 1971, cash flow shall stand at - $700 million and hence at the rate of $2 million

profit (considering cost remain intact at $12 million per unit) per unit aircraft, Tri Star needs to produce at

least 350 units of aircrafts which is not possible even in the most optimistic assumption of 10% annual growth

of air travel over the next decade.

From the above facts, it is quite evident that Tri Star should have not continued with the program at the end

of the year 1970.

ASSIGNMENT 01 ABHISHEK DIXIT, ALOK MISHRA, ANJALI SAHU, GOURAV GARG, RAJAT GUPTA

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